The pound dropped against the euro last week but could slowly recover if the euro does not rise any further. Sterling rose sharply after the Bank of England’s Thursday decision to lift the Bank Rate from 0.25% to 0.50%, but experienced losses when Governor Andrew Bailey and other members of the Bank’s Monetary Policy Committee warned of risks to economic growth and that meeting market expectations for the Bank Rate could eventually lead inflation to fall below the Bank’s target level of 2%.

The forecast for inflation anticipates inflation to remain elevated above the Bank’s target for more than two years and to fall below 2% in 2025. This means that the Bank might avoid raising rates in 2023, despite market expectations.

Thursday’s European Central Bank (ECB) policy decision

Sterling fell due to the Bank of England’s cautious tone and concerns about the effects of the recent increase in energy and international traded goods prices. But it was the hawkish shift of the European Central Bank last Thursday that also deflated the pound and boosted the euro. The foreign exchange market moved sharply and resulted in the euro rising higher. After ECB president Christine Lagarde said that Eurozone inflation risks have increased, financial markets expectations for a potential end of negative interest rates rose. The euro rally could extend, and this will be an ongoing risk for the pound.

Rising inflation and cost of living squeeze

Economists have warned on Monday that inflation will hit UK economic growth this year as consumers have to deal with the rising cost of living.  In its latest quarterly assessment of the economy the EY Item Club has cut its forecast for UK economic growth this year to 4.9%, as the squeeze on households’ spending power and the omicron variant slow economic recovery. The EY predicts inflation to hit 7% in the spring and real wages to fall. They also expect the Bank of England to hike the Bank Rate to 1% by the end of this year.

Hywel Ball, EY’s UK chair, says: “The forecast shows that the economy’s bounce back in 2021 was stronger-than-expected and Omicron’s economic impact is likely to be temporary and limited. While the economy and UK businesses may have a softer launch pad for growth this year, they will still benefit from a number of tailwinds in 2022 and 2023. But blowing in the opposite direction will be a squeeze on household spending power which is expected to be a bigger headwind for the economy than the Omicron variant. Inflation is set to reach its highest level in thirty years by the spring and will be well ahead of pay growth. Although the latest forecast says that the economic scarring from the pandemic is likely to be minimal, policymakers still face the challenge of how they help support households through the forthcoming squeeze on their finances and give companies the confidence needed to unlock business investment. The push towards Net Zero certainly creates an opportunity for investment growth.”

What to watch this week

The pound will be sensitive to any comments made by BoE Chief Economist Huw Pill on Wednesday’s online event with the Society of Professional Economists and Governor Andrew Bailey on Thursday’s online event hosted by TheCityUK. Friday’s UK GDP figures for December and the final quarter will also reflect the effects of the Omicron variant on economic activity into the end of the year. The GDP is expected to have fallen by -0.5% in December and to have grown by 1.1% for the final quarter.

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The pound rose against the euro and the dollar after the Bank of England voted to raise interest rates to 0.5%. The Monetary Policy Committee (MPC) voted by a majority of 5-4 to increase the Bank Rate by 0.25%.

While Governor Andrew Bailey, deputy governors Ben Broadbent and Jon Cunliffe, chief economists Huw Pill and external member Silvana Tenreyro voted to raise the rate from 0.25% to 0.5%, deputy governor Dave Ramsden, and Catherine Mann, Jonathan Haskel and Michael Saunders all voted for a 0.75% increase. These four members argued that monetary policy should tighten faster, to “reduce the risk that recent trends in pay growth and inflation expectations became more firmly embedded.” This points that further hikes will be coming soon.

Inflation to rise above the Bank’s 2% target

The Bank of England has increased its inflation forecast and expects inflation to increase 7.25% in April. This is over three times higher than its 2% target and shows how difficult the cost of living squeeze will be.

The Bank said that energy bills will rise in April while goods prices will also continue to increase. The rise in inflation reflects this rise in global energy and tradable goods prices. Inflation will rise more in the coming months before peaking at around 7.25 in April.

Bank will start unwinding its £895bn stimulus package

The Committee voted collectively for the Bank of England to begin to reduce its £875bn stock of UK government bonds, by not buying new gilts when they mature. They also voted to reduce its £20bn stock of corporate bonds on its balance sheet, by not reinvesting maturing assets and by selling bonds.

Subdued growth

The Bank also warned that unemployment will rise, and growth will slow down, as the Omicron variant impacted on economic activity in December and January. While a recovery is expected in February and March, in the longer term, UK economic growth is “expected to slow to subdued rates.” Rising inflation will hit household incomes and spending and push up unemployment. The BoE explained: “The main reason for that is the adverse impact of higher global energy and tradable goods prices on UK real aggregate income and spending. As a result, the unemployment rate is expected to rise to 5% and excess supply builds to around 1% by the end of the forecast period.”

The Bank anticipates unemployment to fall further to 5% by the start of 2023.

Earning Squeeze

The Bank of England is concerned that UK families will suffer in terms of living standards as disposable incomes will shrink by 2% this year, and by another 0.5% in 2023. This is the biggest reduction since 1990.

Sky News’s Ed Conway said: “The fall - largely a consequence of higher energy bills but also the rising tax burden and comparatively weak earnings - is considerably bigger than 1.3% fall in 2011, up until now the biggest squeeze since the statistical series begin.”

As the governor of the Bank of England said, the “hard message” is that “we are facing a squeeze on real incomes.” So, this is why the Bank decided to raise interest rates, otherwise the effects will be much more damaging.

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The pound has risen to multi-year highs following buying interest ahead of the Bank of England’s rate hike decision on Thursday (3rd February). Economists are warning that the pound could later in the year fall under pressure following economic disappointment.

Sterling recorded gains against both the euro and the US dollar as investors anticipate a second Bank of England interest rate that would possibly take the Bank Rate to 0.50%.

Bank of England

Market expectations for higher interest rates show that investors believe that inflation will remain high above the Bank’s target of 2% for a longer period of time. This will encourage the Bank to proceed to further interest rate hikes as the economy is recovering and has shown signs of resilience despite the spread of the Omicron variant. The UK economy has strongly bounced back compared to other major economies.

UK economy

The UK economy shrank during the months of December and January but is expected to rebound in February, according to economists. With restrictions lifted and less employees self-isolating, businesses will slowly return to normal and consumer confidence will rise.

If such expectations are justified and the economy is proven to be on the right track, then the Bank could raise interest rates in February and signal even further hikes in the coming months.

Thursday’s Bank of England meeting will be closely watched by investors for any indications that the Bank will proceed to a faster monetary policy normalisation which could provide support to the pound.

MUFG's Head of Research Derek Halpenny said that the Bank of England will prefer a “more front-loaded” action “with an additional 25bp hike in May helping support GBP versus the euro but later in the year risks of slower growth could push the BoE to the sidelines and result in the pound reversing versus the euro.” Other economists have also warned of slower economic growth later in the year as consumer spending is limited by increased inflation and tax rises, which could push the Bank to abstain from raising interest rates.

Comments from the Bank’s Monetary Policy Committee member Catherine Mann also suggest that it is better to act early rather than to proceed to a high “terminal” Bank Rate later, as to provide support to businesses and act on inflation.

Inflationary pressures

Workers and consumers will experience a loss of earning power as inflation rises and exceeds 7.0% in the first half of the year. Utility bills are expected to rise in April too, putting more pressure on households. The introduction in April of a hike to employee and employer National Insurance and the fact that income tax bands will be frozen, will result in households paying higher taxes.

Economists have also noted that both the euro and the US dollar will face challenges ahead, with the dollar’s rally to end this year. The US dollar dominance has been priced in as the Fed now seems ready to deliver up to 7 rate hikes this year, which means the greenback might start seeing some underperformance against advanced economies that become more aggressive in tightening their policies.

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Sterling strengthened against the US dollar on Monday and for a short time hit 23-month highs against the euro at the beginning of the week. The British currency is expected to rise further if the Bank of England proceeds to raise interest rates for the second time in a few months.

Markets anticipate that the Bank of England will most likely raise interest rates on Thursday in an attempt to fight rising inflation levels which could reach 7.0% and remain above the Bank’s target for months.

Markets’ great expectations

These expectations have helped boost the pound, but to continue offering support the Bank will need to act accordingly and not disappoint the markets. More than 100 basis points of rate hikes are now expected to be delivered in 2022, but such great expectations might be too optimistic, analysts have noted. These expectations have been priced in by markets, so any disappointment, or any indication that there will be less rate hikes could push the pound lower, especially after its recent highs against the euro.

It has been noted that if the Bank proceeds with a 25-basis point rate hike on Thursday while remaining hawkish and positive, indicating that there will be more hikes to come, this will help the pound rise against the euro.  

Craig Inches, portfolio manager at Royal London Asset Management, has said that markets might not expect a more hawkish BoE: “If they move interest rates to 0.5%, the market will expect them to announce they won’t be reinvesting the proceeds of the March 2022 gilts .... that will be the first sign we see of how markets react to balance sheet reduction.” Money markets are pricing rates at 1.25% by the end of the year.

Inflation

Analysts have noted that the Bank itself will not want to hurt markets and lower expectations as a strong pound will help ease inflationary pressures. They note that the Bank is actually welcoming the strength in the pound as it will help it fight the rising energy prices.

A strong pound means that the cost of imports will be cheaper, and because the UK is a net importer, this will act as a deflationary source.

HSBC noted that the BoE would signal even higher inflation ahead, or that it will cut its balance sheet: “If the terminal rate were to be adjusted much higher, due to either of the above forces, it would provide more ammunition for rate hikes and would create a less negative backdrop for sterling.”

ING expects the Bank to hike rates 25 basis points and raise their inflation forecasts while clarifying that medium-term growth has not been affected by Omicron. If the Bank decides to go against market expectations, then it will possibly justify such a move by saying that more time is needed to gather more data regarding Omicron’s impact on the economy.

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The pound is up against the euro more than 1% this month. The BoE is expected to proceed to a second 25-bps interest rate hike on Thursday. For those exchanging the pound against the euro, it will be interesting to see whether the British currency will rise further if the divergence between Bank of England (BoE) and European Central Bank (ECB) monetary policies continues this week too. Sterling is near its highest against the euro, since February 2020, ahead of this Thursday’s BoE and ECB policy decisions. The pound is however set to end the month lower against the dollar, which has strengthened from Fed rate hike bets.

Brexit and Prime Minister’s future

For the British currency, other factors remain into play. The Brexit Freedom Bill passage and UK politics could provide some volatility. In terms of politics, there is optimism in the UK after Liz Truss commented that the Prime Minister’s future is assured. Although Sue Gray’s report is yet to be announced, as it has been delayed due to an ongoing police investigation, Foreign Secretary Liz Truss stated that “The future of the PM is assured.” In a BBC interview, Truss also said: “He’s doing an excellent job on the things that matter -- recovering the economy from Covid, getting Brexit done, getting this country going again.”

While the devolved governments in Wales, Scotland and Northern Ireland have criticised the Brexit Freedom Bill, the Prime Minister has praised it ahead of its official passage. According to Bloomberg: “Legislation building on Britain’s exit from the EU would make it easier to amend or remove statutes that remain on U.K. books, a measure that will help the government strip away regulations costing businesses 1 billion pounds ($1.3 billion), Johnson’s office said in a statement released Monday.”

Any developments relating to Brexit and UK politics will be of interest to those exchanging the British currency against the US dollar. However, markets will now focus on the Bank of England (BOE) and rate hike concerns following positive domestic data.

Bank of England

The Bank of England is expected to raise interest rates on Thursday as concern over inflationary pressures on households is growing. Economists anticipate the central bank to increase its key rate from 0.25% to 0.5%. With rising household costs exacerbated by high energy bills the Bank’s monetary policy committee (MPC) is anticipated to vote unanimously for a rate rise.

Chief UK economist at Goldman Sachs Steffan Ball, said the MPC would probably vote to raise borrowing costs on Thursday, and could raise rates as much as 1.25% by November this year. Ball said: “We now expect the Bank of England to hike in back-to-back meetings through May, in order to demonstrate to markets and businesses that the MPC is serious about the inflation target.”

Thursday’s policy decision is due out at 12:00 and the pound is expected to rise.

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The pound fell against the US dollar following the January Federal Reserve policy announcement, as the Fed warned that US interest rates could rise in March. Further rate rises by the Fed could also be announced and at a quicker pace, the Fed suggested. The pound has weakened against a strengthening US dollar.

Global risk sentiment was also weak due to concerns about a faster policy tightening by the Fed and political tensions between Russia and Ukraine. As a result, equity markets fell, which further pushed the dollar higher against the pound.  

Sterling was also undermined by the current political turmoil over UK Prime Minister Boris Johnson’s alleged lockdown parties in Downing Street. This has added more pressure on the GBP/USD pair, but expectations that the Bank of England will hike interest rates could help limit losses.

So far, the GBP/USD pair remains at the mercy of the US dollar dynamics, considering also that there are no relevant macroeconomic data coming out of the UK.

Fed announcement

Global markets are unnerved today after the US central bank signalled it is ready to raise interest rates. Federal Reserve chair Jerome Powell was hawkish in tone at last night’s press conference and said that the Fed was ready to raise interest rates in March. He also noted that an aggressive cycle of interest rate rises at coming meetings was also possible.

Powell told reporters there was “quite a bit of room to raise interest rates without threatening the labor market.” He warned that inflation was higher than the Fed’s target while supply chain issues pose considerable risks if they continue to persist.

Investors are now expecting a sharp rise in interest rates this year, after Powell suggested that the Fed could tighten policy faster than expected.

The Fed reaffirmed market expectations for a rate hike in March, which pushed US Treasury bond yields higher. The 2-year US bond yield rose and pushed the USD to the highest level since mid-December.

Pound to strengthen

Financial analysts have noted that the uncertainty around Prime Minister Boris Johnson will unlikely not persist. Additionally, with more positive economic data and Covid restrictions easing, the pound should go higher.

Economists at Westpac said: “The easing of covid restrictions and moves away from working from home should lift economic activity. Nov employment and production were stronger than anticipated and inflation data was notably higher. Dec’s Omicron impacted retail sales were surprisingly weak, but recent survey data suggest that demand has remained firm and maintain potential for another BoE hike.”

In relation to PM Johnson’s position, they pointed out that although there is discontent and calls for him to resign, 15% (54 MPs) of Tory MPs still need to express their lack of confidence to trigger a leadership challenge. While there may be challenges to his leadership, this may be positive as it will end uncertainty and support the pound.  

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The Pound has strengthened on Friday and is on track to reach its biggest weekly rise since October following the Bank of England’s announcement on Thursday to raise interest rates. The BoE is the first major central bank to raise interest rates since the start of the pandemic. This week, the Federal Reserve has also signalled its intention to tighten its policy in 2022, while the European Central Bank has taken small steps towards rolling back its pandemic-era stimulus on Thursday. It has started by wrapping up its pandemic bond purchases next March. But the Bank does not appear to be raising interest rates soon.

UK interest rates rise to 0.25%

The Bank of England surprised markets on Thursday by raising interest rates to 0.25%. The pound, gilt yields, and bank stocks rose in response of the positive news.

On Friday (17 December 2021), strong UK retail sales data for November along with higher inflation have increased expectations of a February rate hike too.

Retail Sales

The latest positive data on retail sales and resilient consumer confidence have confirmed that consumer demand remains strong. British retail sales rose by 1.4% in November, following strong trading on Black Friday and in the period leading up to Christmas, according to the Office for National Statistics. Retail sales are 4.7% higher than a year before when many shops were closed due to the lockdown. Spending on clothes rose by 2.9%, while other stores such as computer, toy and jewellery shops had a 2.8% growth. With people returning to actual stores, malls and the high street, online retail sales fell to its lowest since the lockdown in March 2020.

Retail sales rose in October too, with consumer spending remaining strong before the Omicron variant hit the economy. According to Heather Bovill, deputy director of the ONS, “Omicron is now casting a shadow over the economy, of course. The work-from-home guidance introduced last week under plan B measures in England has left city centres depopulated, and hospitality firms warn that trading had plunged.”

Expect more rate hikes BoE's Huw Pill says

With inflation shooting higher, the Bank of England chief economist Huw Pill said that the central bank would need to raise interest rates further. Speaking on Friday, Pill explained that the rate increase from 0.1% to 0.25% on Thursday will not be the last and there will be a lot more rate hikes, if inflation remains at its current level. Pill noted that inflation pressures possibly centred around wage pressures in a shrinking labour market will prove persistent.

The hike before Christmas

Deutsche Bank has called Thursday’s Bank of England rate rise “the hike before Christmas.” Deutsche bank’s UK economist, Sanjay Raja, stated that “prudence around inflation” has forced BoE into action. As she clarified, by acting now, the central bank has maximised its chances of meeting their target in two- or three-years’ time.

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The pound has fallen since last week’s Bank of England (BoE) monetary policy decision to leave the Bank rate unchanged at 0.10%. While it is expected to stabilise the following days, analysts do not anticipate considerable gains for the pound in the near term.

The BoE’s decision to keep monetary policy unchanged took markets by surprise but it chimed with members of the Monetary Policy Committee comments that the Bank wanted to wait and see further evidence about the state of the economy and the health of the labour market, especially the impact of the furlough scheme which ended in September. Analysts still expect a February rate increase instead of one in December.

Possible interest rate rise

The BoE wants to wait and analyse the impact that the end of the furlough scheme will have on the economy, and employment in particular, before making any decisions on raising interest rates. Some of the data will become available in December and more later in January and February. This is why the November interest rate rise was too soon, whereas other ones in December, February 2022 or some time later, appear to be more likely possibilities.

Before the next Bank of England meeting on the 16th of December, analysts and policymakers will have the chance to examine two jobs reports and two inflation reports, which will determine how the Bank will act if there is to be a 15bp December hike. Since markets have not yet priced in a December move, there could be potential for Sterling to rise.

Pound outlook

Analysts believe that there is still potential for the pound as markets digest the news and adjust to a less aggressive policy response in the next meetings.

At the same time, for inflation to return to a target that will be within expectations, the Bank rate will need to rise. The Governor of the Bank of England, Andrew Bailey, said that the BoE would not raise rates to 1 per cent by the end of 2022, because according to the bank’s forecasts inflation would fall below its 2 per cent target in the medium term if they tightened monetary policy too much. Higher inflation is expected to be transitory, leading to an increase in consumer prices, which would have been higher if interest rates rose even a little. The Bank, however, does not expect inflation to fall below 3 per cent until the spring of 2023, which means there will be a period of higher inflation.

Brexit

Brexit is adding some pressure on the pound at the beginning of this week, as reports that the UK is preparing to trigger Article 16 of the Northern Ireland Protocol are growing. Senior Government and EU figures have held discussions to prepare on the possibility of the UK triggering article 16 of the Northern Ireland protocol, a move that both Dublin and Brussels expect in the coming weeks. The move could create a crisis in EU-UK relations. Minister for Foreign Affairs Simon Coveney said that the EU could retaliate by withdrawing the entire free trade and co-operation agreement, reigniting fears of a “no-deal Brexit” and tariffs on trade.

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The pound fell following the Bank of England’s decision on Thursday to keep interest rates unchanged. The decision has taken markets by surprise whose expectations for a November rate hike were very high. Markets are now lowering their expectations for future UK interest rate hikes, as it was also suggested that the December rate hike might also be postponed.

The disappointing news has hurt the pound, which experienced the biggest fall since 28th of September. With the market expecting more than one hike and the bank rate going as high as 1.10% by June 2022, the news was really unexpected. Economists believe that a December or February hike is still possible, which could offer support to the pound. On Friday, the pound remained lower, but tried to stabilise.

Bank Decision

The Bank explained that they have postponed the rate hike as they wanted to wait and see the impact of the government's job support scheme which ended at the end of September.

Uncertainties such as rising energy costs impacting households, ongoing supply chain disruptions, and Brexit tensions could all affect economic recovery. Inflation is a key concern for policymakers as  is expected to rise to around 4% in October and 5% in April 2022. The MPC stated however that inflationary pressures were “most likely to prove transitory.”

Rates could rise in the coming months

The Bank of England noted that interest rates could rise in the coming months if the economy improves. The key question now is whether the Monetary Policy Committee will announce the next rate in February when it produces its new forecasts. The possibility of a rate hike in December is just below 50%.

If there is a rate hike in December this will depend on November's job report for the October period. The labour market report on 16th of November is expected to show positive figures that reflect a healthy labour market which could support a small interest rate rise. A positive jobs report could therefore offer support to the pound.

Economists at MUFG Bank expect interest rate hikes and they have warned that the pound could fall further if the Bank fails to curb inflation. They said: “We still believe that the BoE will raise the policy rates closer to 1.00% by the end of next year. We have only pushed back the timing of our forecast for two further 0.25 point hikes in 2022, and now expect those to be delivered in May and August bringing the policy rate to 0.75%. We remain sceptical though that it will rise beyond 1.00% in 2022.”

They added that downside risks for the pound could continue building if markets become more concerned that the BoE will fail to respond to higher inflation.

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The Bank of England’s policy decision is due out at 12GMT on Thursday. The question of whether the Bank will raise interest rates today for the first time since the pandemic is on every trader’s and financial analyst’s mind. The Bank is in a difficult position as it has created uncertainty about its intention to raise interest rates and whether now is the appropriate time.

Governor Andrew Bailey’s difficult position

For many analysts, the Governor of the Bank of England, Andrew Bailey, seems to have made a mistake by exaggerating the prospects of an interest rate rise. City traders are now expecting an interest rate rise and the governor will be criticised today whatever happens. If there is an interest rate hike, it will appear that the Governor was forced to deliver it so he wouldn’t disappoint markets. On the other hand, if rates do not rise, he will be blamed for signalling that interest rates were going to rise. If rates remain unchanged, and inflation pressures prove to be temporary, then this will be the least bad alternative.

Previous Monetary Policy Committee meeting

In the last MPC meeting in September, all 9 members voted to keep rates at their current level of 0.1% as heightened global cost pressures were said to be temporary. Although nothing has changed since September, a possible reason to raise rates would be to control inflation. However, economists have pointed out that this is unnecessary as inflation goes up temporarily following events such as the pandemic but eventually things return to normal.

Rate hike could push household costs higher

A rate hike will hurt households which are already struggling with rising energy costs and could push up the cost of borrowing on credit and increase mortgage costs for those who do not have a fixed rate. With supply chain problems also affecting growth, a rate rise could also weaken economic recovery.

Some of the reasons that inflation has been higher, such as rising gas prices and raw material shortages are temporary, so it will be damaging to raise interest rates early, as some economists have argued.

Thomas Pugh, economist for RSM UK, also believes the Bank will wait and not hike today: “But at 63% probability, this is still a close call. We expect the vote to be 5v4 in favour of leaving interest rates at 0.1%. This might imply a glass half-empty/half-full policy of keeping the BoE rate at near-zero for another MPC meeting, or two, with forward guidance preparing the markets for a rate hike in December or early 2022.”

How will the pound react?

A cautious Bank that announces a rate hike in November could push the pound lower, as markets are expecting higher rates over the course of 2022. Other analysts also support the view that the pound might weaken as possibly the Bank will find it difficult to satisfy market expectations.

With the market already expecting rates to rise towards 0.50% by year end, any hawkish surprises from the Bank will be limited so the potential for the pound to rise further will also be limited.

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