Despite Sterling rising yesterday following the Bank of England’s positive tone and the prospect of an early rate hike in 2022, on Friday it fell.

Asian and European stock markets were also down on Friday as well as risk-oriented currencies as the potential default of Evergrande can have significant repercussions on markets.

Pound and BoE

After the Bank of England’s meeting on Thursday, markets have brought their expectations forward as now the BoE is expected to start a rate hike cycle with a first increase in May 2022, followed by a second one in November 2022. While there are still uncertainties ahead for the pound, the British currency is still forecast to strengthen against the US dollar and the euro over the medium-term, as some analysts believe.  

Rate hike expected in early 2022

With markets now pricing in the first rate in the first quarter of 2022, the pound will find support, despite questions about the country’s economic recovery. Challenges will continue to exist, including unemployment and labour shortages that have become more prominent due to Brexit. Some analysts believe that if unemployment does not rise then the Bank’s Monetary Policy Committee could even add a small rate hike as soon as February. With market expectations for a rate hike already priced in, it is likely that the Bank will have to raise rates in early 2022 as it could otherwise create confusion and push the pound lower. For example, big banks such as JP Morgan have brought their expectations forward for a rate rise in early 2022 following the Bank’s announcement yesterday. Capital Economics said: "The Bank is moving closer to raising interest rates. As such, we now think that rates could rise in early 2022, rather than in 2023 as we had previously thought." They also added: "Given the gloomy tone of the recent news on economic activity, we had expected the MPC to place some weight on the downside risks to GDP growth.” However, the Bank’s minutes stressed price stability and the inflation target which remains the same. The Bank highlighted that growth uncertainties were external and depended on global supply chain limitations.

For Sterling, any news about when the rate hikes will start or the vote on QE will be key. Both Dave Ramsden and Michael Saunders voted to lower the purchase rate to £840bn instead of the £875bn. The fact that two policymakers want to tighten the policy is important.

Earlier interest rate hikes will offer more support to pound

With interest rate expectations and a first rate to take place for Q1 next year, the pound is expected to find support. It could rise even further if such expectations move even more forward.  While raising interest rates might not affect inflation, what other Central Banks do does have an effect on global markets and policy. The ECB and the Federal Reserve have both announced that they will begin the tapering and reduce their stimulus support, and if the Bank of England does not follow suit the pound could go lower, something that could push inflation to rise and import prices to go higher.

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The Bank of England remains on track to raise interest rates in the first half of 2022. The pound rose against the euro and US dollar following the bank’s update to keep rates the same. The Monetary Policy Committee voted 9-0 to leave the Bank rate at just 0.1% and to maintain its quantitative easing bond-buying programme at £895bn. Deputy governor Dave Ramsden and Michael Saunders, voted against this, as they wanted to stop the QE programme early by reducing the amount of UK government bonds the BoE buys. While the bank was not 100% yet positive as there are uncertainties about the global economy and the labour market, the pound is expected to regain some of its losses but not to climb to new highs.

According to Bloomberg, City traders have revised their forecast for the first interest rate to 0.25% after the Bank of England’s outlook for the UK economy has improved and that tightening of its QE programme could commence soon.  After Thursday’s meeting, markets now expect a 15-basis-point increase in March 2022, a month earlier than their expected one for May. They also expect a rise of 0.5% in November 2022. With markets now pricing an increase in March and two hikes by the end of next year, investors will be focusing on the bank’s November meeting when a new set of forecasts will be announced.

Inflation

The Bank of England has warned that inflation will rise above 4% by the end of this year, due to the energy crisis. The rise in gas prices is considered a risk to its projections for inflation and it has warned that inflation could remain above 4% into the second quarter of next year making things harder for households. The MPC expects that global cost pressures would prove temporary.

Growth forecasts lowered

The Bank of England has lowered its growth forecasts as supply chain problems are impacting output. Expectations for growth in the third quarter have been revised from 2.9% to 2.1%. The Bank has warned that supply problems such as access to raw materials and staff shortages are affecting economic growth. The Bank also highlighted that global recovery has lost momentum and inflationary pressures will continue.  

Tightening monetary policy

The case for tightening monetary policy seems now stronger. Consumer price inflation rose to 3.2% while global cost pressures and supply problems are pushing consumer goods prices higher. CPI inflation is expected to fall back to the bank’s 2% target in the medium term, but the bank has also pointed out that: “Indicators of households’ medium-term inflation expectations have increased in recent months, with the Citi/YouGov five-to-ten year ahead measure at its highest level since 2013 in September.”

The BoE is also under pressure, as other central banks such as the ECB and Federal Reserve have announced that they will begin unwinding their financial support. If the BoE does not act in the same timeline, Sterling could fall, pushing inflation and prices higher. A rising pound will push the cost of imports lower and will act as a deflationary force.

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The pound was lower on Wednesday after investors became less confident about an earlier rate hike by the Bank of England, which is now likely to be delayed due to weak economic data. A weak US dollar and a stronger risk sentiment following news that Evergrande would repay a yuan-denominated bond on Thursday have not helped to support the pound.

Risks for the pound

The main event for the pound this week is Thursday’s Bank of England decision, and investors seem to have moved from expecting a hawkish BoE to grasping the fact that an interest rate hike is now more than six-months away due to the release of disappointing economic data. The currency market is expecting at least two rate hikes by the end of 2022, but now such expectations are considered too optimistic. With the market pricing the fact of an earlier interest rate for some time now, the realisation that the tables have turned, and a rate hike might take a while longer, means that the pound could react by falling. Sterling could find support if the BoE clarifies its timeline for raising rates starting early next year, but this is unlikely, analysts have noted. The Bank’s expectations will also be shaped by the health of the labour market, especially after the furlough scheme is completed at the end of this month, and analysts expect unemployment to rise. The BoE will also take into account disappointing data for July, retail sales’ numbers in August, and high inflation.

The pound was also weaker against the euro as investors are waiting to hear form the Federal Reserve any hints on the direction it will take for its future policy, including whether it will start tapering its bond buying by November.

Factors that could support the pound

The possibility of Britain joining the North American free trade deal, an idea that has been shared by media, could boost UK-US trade and help offer support to Sterling. As a UK government figure said, the UK is interested in pursuing this option but “The ball is in the US’s court. It takes two to tango.”

The trade partnership between the US, Canada and Mexico, is now a possibility after Boris Johnson failed to secure a bilateral deal with Washington. It appears that a direct free trade agreement (FTA) with the UK is not something that the president Joe Biden will be interested in pursuing and the Prime Minister said that Biden “has a lot of other fish to fry.”

The UK government’s interest in joining the North American deal follows the opening of talks for the UK to become a member of the CPTPP Pacific trade group. The likelihood of Britain joining NAFTA is an attempt to secure a tariff-reduction deal as new barriers have been erected to trade with the EU with Brexit.

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The pound was higher against the US dollar on Monday amid little economic data releases and thin trading. The US dollar fell after Friday’s dovish speech by Fed Chair Jerome Powell. Jerome Powell indicated Friday that the central bank will possibly begin tapering before the end of the year, but a rate hike was not imminent as there is still “much ground to cover” before the economy reaches full employment. At the same time, there could be some risk ahead for the pound, due to renewed Brexit concerns.

Jackson Hole symposium

In his much-anticipated speech at the Jackson Hole symposium, Fed Chair Jerome Powel said that the central bank could start tapering its stimulus programme by the end of the year, easing market fears for a quicker withdrawal of its funding.

The Fed took its benchmark rate down to almost zero and accelerated its quantitative easing programme in an attempt to resuscitate the economy during the early days of the Covid-19 pandemic.

The question of when the Fed will begin to tighten its programme has been the main concern for markets for some time now, and it might remain as Powell avoided to give any definite answers. The Fed is aware that any specific answers could seriously impact the global economy, this is why it has chosen to postpone any reduction of its funding.

“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test,” Powell said during the summit. He added that inflation is close to the Fed’s 2% target rate, but “we have much ground to cover to reach maximum employment.” Markets reacted positively to Powell’s comments, with major stock indexes rising higher.  

Fed Vice Chairman Richard Clarida also agreed with Powell’s remarks. He explained that tapering could be possible by the end of this year, as long as labour gains continue: “I think that if that materialises, then I would support commencing a reduction in the pace of our purchases later this year,” Clarida noted.

The Fed said that “substantial further progress” will need to be seen before tightening policy. Powell said that in terms of inflation the “test has been met” and that there “has also been clear progress toward maximum employment.” He said that the Fed agreed at the July Federal Open Market Committee meeting that “it could be appropriate to start reducing the pace of asset purchases this year.”

Powell defended the Fed’s policy and decision not to make an “ill-timed policy move” and stated: “Today, with substantial slack remaining in the labour market and the pandemic continuing, such a mistake could be particularly harmful. We know that extended periods of unemployment can mean lasting harm to workers and to the productive capacity of the economy.” Additionally, he stressed that the delta variant “presents a near-term risk” but “the prospects are good for continued progress toward maximum employment.”

Renewed Brexit concerns

The UK government supply chain crisis could have a significant impact on Christmas and create further food shortages over the next year too. Iceland, Nandos, KFC, McDonald’s, and Tesco are among the many businesses that are reporting stock issues as a result of lorry driver shortage due to Brexit. Restaurant chains Nandos and KFC are facing chicken shortages, McDonald’s is finding it difficult to make milkshakes and Iceland is running out of bread and soft drinks. The problem has become noticeable over the summer when social media was flooded with images of empty shelves.

The disruption was then largely blamed on the “”, but businesses have for a long time now warned of a chronic shortage of lorry drivers due to Brexit. Speaking to BBC Radio 4’s Today programme, Iceland managing director Richard Walker said the lack of lorry drivers “is impacting the food supply chain on a daily basis.” “We’ve had deliveries cancelled for the first time since the pandemic began, about 30-40 deliveries a day,” he said.

British Poultry Council chief executive Richard Griffiths said last week that “When you don’t have people, you have a problem - and this is something we are seeing across the whole supply chain. The labour crisis is a Brexit issue,” he said.

Nick Allen of the British Meat Processors Association warned that such shortages will impact on Christmas staples: “We are cutting back and prioritising lines and cutting out on things, so there just won’t be the totals of Christmas favourites like we are used to.”

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If strong domestic data confirm expectations that the UK economy is growing, then the pound could rise higher. According to a recent UK business activity survey, the August Bank holiday weekend is expected to push business revenue higher as more consumers flock to the shops.

Sterling will remain volatile due to global developments and concerns about the spread of the new Covid variant, but UK economic growth and Bank of England policy will also be key drivers of the currency. The release of better-than-expected economic data will offer much needed support to the economy and the pound.

Pound sentiment suppressed due to labour market concerns

Concerns that a labour shortage could impact on the UK’s economic recovery have been expressed in the quarterly survey from the Confederation of British Industry (CBI). A quarterly survey conducted by the CBI from July 29 to Aug. 16, showed that optimism was at minus 17% this month, down from May’s 47% as companies struggled to bounce back after the pandemic. Charlotte Dendy principal economist for the CBI, said on Thursday that “Firms in sectors such as hotels, restaurants and travel do not expect this strength to persist into the next quarter, reflecting the pressure that consumer services firms continue to face.” Labour shortages could weigh on businesses’ investment plans for the next 12 months.

For services businesses, there are added costs and higher wages after the pandemic that they need to resolve, while Brexit has made it more difficult to access talent from the EU. An index tracing the outlook for costs showed that it has reached the higher in two years and is starting to filter through to the prices, with average selling prices rising at the fastest rate since 2019.

Bank of England interest rate hike

The Bank of England is expected to raise interest rates in 2022, but analysts say that for the pound to rise higher in a sustained manner it will take an earlier hike, or more than one interest rate rises after 2022. Markets are hopeful that the economy will expand, and the labour market improve in order to see any substantial shift higher in the pound’s performance.

Short-term pound volatility

Federal Reserve Chair Jerome Powell's speech to the Jackson Hole economic conference on Friday will possibly offer few new hints about ending its quantitative easing programme. If it does show any clear indication that it intends to proceed with tapering the $120 billion in monthly purchases of Treasuries and mortgage-backed securities, then this will have a negative impact on global economic growth, but it will be supportive of the Dollar. If the Fed indicates that they are not yet ready to proceed to reduce its massive asset purchases, as the delta variant continues to spread rapidly igniting further fears of an economic slowdown, then the US dollar will fall. As Goldman Sachs economists have said earlier this week, Powell will be cautious not to lock in a specific date for starting the taper and he would keep the possibility for starting in November open.

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The British currency rose against the US dollar and the euro, after the return of investor confidence.  With the recovery of major stock markets, investor risk appetite returned helping boost currencies such as the pound which are closely influenced by global market sentiment. The pound is considered a risk currency and is vulnerable to risk-off sentiment at times of risk-on.

Major concerns such as the Delta variant and the Fed’s removal of its stimulus programme will be the main drivers for global currencies such as Sterling. While there is still significant uncertainty about how the delta variant will affect markets, most developed economies are expected to grow steadily. Nonetheless, Sterling will remain sensitive to global developments than domestic economic data, as the economic calendar is thin with releases of little impact.

Risk on and Risk off sentiment

The widespread risk on and risk off sentiment, also known as RORO is the major driver of currencies in the market at the moment. Two of the key concerns of global investors are the withdrawal of the Federal Reserve’s stimulus and the rapid spread of the Delta variant in Asia.

But what is exactly risk sentiment? Simply, risk-on risk-off refers to shifts in investment activity as a result of global economic events. The foreign exchange market is basically affected by changes in the ways investors behave and where they choose to invest. The theory states that investors engage in higher risk trades when the risk is considered low and avoid high-risk investments when the risk is perceived to be high. So, investor appetite changes depending on global sentiment and whether risk is high or low. For example, the 2008 financial crisis was considered a risk-off year, as investors avoided risk by selling their risky assets and turning towards low or no risk positions such as U.S. Treasury bonds.

The risk-on risk-off sentiment is also affected by different asset classes, as some carry higher risks. Stocks are riskier than bonds and so when stocks are preferred more than bonds then the market is considered a risk-on environment. A risk-on environment is one where investors invest into riskier assets.

A risk-on environment is usually one where a combination of positive economic factors, data and events co-exists, showing that the market is healthy and strong, and risk is limited. Strong economic data such as corporate earnings, an optimistic outlook, and supportive central bank policies reflect a market where investors have more room to take on more risk.

Federal Reserve and monetary stimulus

In the coming week, the fundamental concern for markets will be the Federal Reserve's decision to withdraw monetary stimulus. On Thursday, Federal Reserve Chair Jerome Powell will give a speech at the Jackson Hole central banking symposium and investors expect him to announce the Fed is ready to start reducing stimulus, possibly as soon as this September. While this is good news for the  US dollar, stock markets which have been supported by the Fed’s funding will find the news disappointing. This will also affect the British pound which could fall following such an announcement. For some analysts, Powell might avoid bringing up monetary policy at the symposium, but others believe that the dollar will weaken if the Fed postpones the planned withdrawal of its funding.

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The weakened global investor sentiment has kept the British currency under pressure against both the US dollar and euro. Analysts believe, however, that this will only be temporary as has already been seen throughout the last year. Fears of a global economic slowdown due to the pandemic and the spread of the Delta variant in Asia, as well as expectations the Federal Reserve will withdraw stimulus have hurt global sentiment.

The pound is mainly impacted by Bank of England policies and domestic economic developments but also by global investor sentiment. As it stands, there is a risk-off/risk-on binary which is affecting the foreign exchange market. Pro-cyclical currencies such as the AUD, CAD, and NZD tend to appreciate during good times, as opposed to countercyclical ones which appreciate in bad times. In a risk-off world where traders are not optimistic, and want to avoid risks, such currencies as the AUD and NZD become more vulnerable. In the current situation, the spread of the pandemic and the rapid rise of the Delta variant in Asia has hurt these pro-cyclical and commodity currencies as their main trade partner is Asia.  The pound is also sensitive to global risk sentiment. The trajectory of the pound will then depend on investor sentiment.

Market sentiment: Factors to consider

The main concerns for markets are as we mentioned the Delta variant’s spread in Asia and worries about the Federal Reserve withdrawing financial support. These concerns have prompted traders to wind back their bets on a strong economic recovery. With the general sentiment being cautious and nervous, the pound is under pressure, while the US dollar has strengthened.

  • Federal Reserve

The Fed is expected to announce a reduction to its quantitative easing programme some time between the Jackson Hole Symposium and September. This will open the way to a rate hike towards the end of 2022 and beginning of 2023. The news has now pushed the US dollar higher, whereas the pound is as low as it was the end of July.

  • Fears of slowing economic growth

The expected taper to the Fed’s programme combined with fears of slowing economic growth as Asian economies grapple with rising Covid cases has clouded market sentiment. The two factors are interrelated, as economies are currently dependent on and expectant of support from their central banks. With the Fed withdrawing support and the Delta variant spreading across Asia and hurting economic growth, the question is whether this is just a temporary concern. For analysts this won’t change markets massively and that the Fed’s anticipated tapering has already been priced in. The Covid threat has been there and continues to affect markets, and any weakness is seen by traders as an opportunity to buy cheaper assets.

So, this is seen as history repeating itself, with the pound’s weakness being just temporary.

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Sterling rose to an eight-month high due to dollar weakness and after Federal Reserve Chairman Jerome Powell said on Thursday that the Fed will tolerate inflation above 2.0%. This gave investors hope that the Fed will not try and control economic growth, something that could hurt the US dollar in the near future. On the other hand, on Friday, after Bank of England Governor Andrew Bailey’s speech, the pound remained unmoved. Both Bailey and Powell gave their speeches at the Jackson Hole central bank symposium which was held online this year rather than at the usual ski resort in Wyoming.

Fed’s decision marks a significant shift in monetary policy

The Federal Reserve has approved a significant change in the way it sets its interest rates by abandoning the usual practice of raising them to control higher inflation, something that will leave US borrowing costs extremely low. By signalling that it wants inflation to rise moderately above its 2% target, the Fed confirmed that inflation targeting in a world of lower interest rates is a thing of the past.

Andrew Bailey’s speech

On Friday, the Governor of the BoE delivered his keynote address to fellow central bankers online and not from the actual ski resort in the Grand Tetons where the conference was traditionally organised since 1982.

In his speech, Bailey said that central banks have a lot of strength to use quantitative easing to manage crises, such as Covid-19. As he noted characteristically, “Go big (and fast) or go home.”

The Bank of England governor did not provide details over short-term policy or on the UK economic situation, but he did reassure the financial community that the Bank will be able to deal with future crises: “We are not out of firepower by any means, and to be honest it looks from today’s vantage point that we were too cautious about our remaining firepower pre-Covid. But, hindsight is a wonderful thing when you have it.”

He also said that the Bank won’t seek to restrict monetary policy until there is significant economic progress: “The committee does not intend to tighten monetary policy until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably. This important step is intended to ensure monetary conditions do not tighten prematurely when there are some initial signs of an economic recovery.”

According to Bailey, QE will be “more long-lived” and that the Bank has the power to fight recessions. In regard to Jerome Powell’s comments from yesterday, Bailey said that these suggest that flexibility can be useful for monetary policy and that a different exchange rate environment could justify different approaches.

The Bank of England increased quantitative easing by £745 billion in June, and in March it cut its main interest rate to a record low 0.1%. A paper with the Bank’s conclusions will be published alongside Bailey’s speech.

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The pound has regained its momentum since yesterday, after the positive news of new US Federal Reserve stimulus and the latest post-Brexit trade talks between the EU and the UK.

Sterling rose after Prime Minister Boris Johnson said yesterday that there is a "very good chance" a trade deal will be made with the EU. Both Johnson and the EU Commission President Ursula von Der Leyen agreed that there will not be an extension to the Brexit transition period, which will end on 31 December 2020. The pressure is now on both sides to agree on a post-Brexit trade deal, so the UK does not leave the bloc without a deal. If the UK leaves the bloc without a deal, then Britain will revert to World Trade Organisation terms, which will mean that the UK would have to pay high tariffs and quotas at a time when the country’s economy is dealing with the Covid-19 pandemic.

Fresh Momentum injected into the negotiations

According to Reuters, the hour-long video call on Monday between Johnson and the EU Commission’s von Der Leyen, “has injected fresh momentum” into the negotiations, as “people on both sides with knowledge of the conversation,” attested. The “EU inferred from Johnson’s contributions that he is willing to soften his position and European officials told him they are ready to do the same.” After the call, Johnson said: “I don’t think we are actually that far apart -- what we need to see now is a bit of oomph in the negotiations. The faster we can do this the better: we see no reason why you shouldn’t get that done in July.”

Obstacles Remain

Johnson’s latest communication with the EU comes after three months of trade talks which have ended in deadlock. However, things might not be completely resolved just yet, as EU Council President Charles Michel warned that the EU will not “buy a pig in a poke” as it was not in any hurry to reach an agreement. He said: “We won’t just speed up. We have to remain focused on content and consequences.” While the UK has been pushing to speed up the discussions, the EU wants to make reasonable steps, with the next discussions to resume on 29 June. Johnson explained that he is against the talks “going on until the autumn, winter, as perhaps some in Brussels would like.”

Both sides have failed to reach an agreement on a free-trade deal as well as find common ground when it comes to certain EU standards and demands regarding fishing rights and security which the UK believes are binding it to EU rules. Also, the UK continues to refuse to accept the power of the European Court of Justice to settle any disagreements between the two sides.

Pound Remains Unpredictable

With Brexit negotiations in the background, Paul Meggyesi, Head of FX Research at JP Morgan noted that the pound’s trajectory would remain unpredictable. He said: “GBP is liable to become ever-more idiosyncratic as the UK nears the business end of the entire Brexit process, the last six months of the transition period, with still a trade deal to be negotiated. This puts GBP at the mercy of unpredictable Brexit news flows, and investors should be prepared for potentially quite violent swings in GBP as the market tries to benchmark probabilities of the potential outcomes and eventually moves from valuing GBP on a probability-weighted basis to pricing a central scenario and then the eventual outcome itself.”

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The uncertainty caused by the coronavirus pandemic has certainly affected exchange rates and increased currency volatility. However, the US Dollar is a safe-haven currency, like CHF and JPY, which means traders have turned towards the USD during the crisis, causing it to move higher. In the short term the outlook for the USD appears to be positive. In the long term, though, the currency is seen as dropping, according to recent analyses. But let’s see more closely what is happening to the USD.

Short-term outlook

For many economists, the buying of safe-haven currencies due to the coronavirus will continue in the coming weeks and will strengthen the dollar. Already, the greenback has been steadily rising through 2020, but rose even higher, outperforming its major peers as global governments struggled to contain the virus, enforcing strict lockdown measures that have unavoidably hurt their economies.

Eventually though, in the longer term, the dollar will decline, according to Georgette Boele, senior FX strategist at Dutch investment bank ABN AMRO. Referring to the dollar’s outperformance, Boele said: "Do we expect this trend to continue? In the near-term (up to 3 months) yes, on the longer-term no.” The dollar will possibly rise higher, the Dutch bank predicts, because traders are overoptimistic about how quickly global economies will recover. Once it is realised how badly global markets have been hit, another wave of selling riskier assets and buying “safer” ones such as the USD will be triggered. As Boele explains: "There is an enormous gap between the economic reality and what analysts forecast, on the one hand, and the optimism among investors for the second half of this year, on the other. This should support the U.S. Dollar as most liquid safe haven currency.”

For Boele, the Dollar will find support in the short term if there is a second wave of coronavirus cases, as investors turn again to safe havens.

Additionally, in terms of Sino-American tensions, any increase of anxiety regarding geopolitics will favour the USD.

While the dollar will not be falling any time soon, it is possible that with the easing of the lockdown measures and the risk of a global recession being averted, the greenback might experience downside pressure. 

Long-term outlook

This is why, as Boele asserts: "After macro and earnings disappointments in the next few months, later this year investors could start to look forward to a strong and durable recovery in 2021. Therefore, over the medium term, investors will shy away from safe haven currencies such as the US dollar and Japanese yen and be open for alternatives.”

As economic conditions improve, the dollar could possibly lose momentum. The US Federal Reserve’s QE programme which has increased dollar supply to respond to the coronavirus pandemic will also add to the dollar’s potential woes. Boele said: "Because of the unlimited QE by the Fed, there is already some more confidence in financial markets. As soon as safe haven demand fades, the Dollar will decline. The QE is simply too large for the Dollar to ignore.”

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