Despite Omicron concerns, the pound has hit its highest level against the US dollar since November and its highest level against the euro since February 2020.

Bank of England rate hike

The expectation of inflation rising has helped to push the pound higher as traders now anticipate the Bank of England to hike interest rates in February, after raising them to 0.25% in December. Economists believe that it’s a close call as Omicron is expected to hit economic growth this winter. The economic impact of Omicron might not be huge or long-lasting, but the Bank still needs to tread carefully. While the markets expect the Bank of England to hike rates again at the start of February, some analysts think it might wait a little bit more, until May.

Businesses are facing staff shortages while consumer spending has been much lower in the end of December. Analysts believe that the Bank might wait for more data, and as such a rate hike in May appears to be more likely.

UK Covid cases have peaked

It is beginning to look quite hopeful experts have said, as there are hopes that the UK Covid cases have peaked in all parts of England. New case numbers are starting to fall in the South East and the East of England, and in London. According to official records, as of January 8, new case numbers are beginning to fall in the South East and the East of England, as well as in London, which peaked before Christmas. Cases are rising in other regions but at a much lower pace.

Professor Kevin Fenton, Public Health England’s regional director for London, told the Sky News that the Omicron wave has now peaked in London. He warned that ONS data showed that almost one in 10 Londoners are still infected with the virus and the pandemic is not yet over.

While case numbers and hospitalisations are dropping, scientists have highlighted the significance of vaccines which are believed to have prevented intensive care wards, and the NHS, from being overwhelmed.

The Prime Minister confirmed that ministers are considering reducing the self-isolation period for fully vaccinated people who test positive for the virus to five days from the current seven.

The prospect of a drop in cases suggests that an economic rebound into the second half of Q1 is possible and this in turn will validate the prospect of a February interest rate hike.

Economists have noted that the most negative economic impact of Omicron is the rising number of self-isolation cases and weak consumer sentiment. The combination of the two could further slowdown economic activity.

If there is an economic rebound, then the Bank is expected to raise interest rates and markets are pricing more than a 70% chance of another UK rate rise next month. The rise of US and UK bond yields has also offered support to the pound so far. Sterling remains the best performing G10 currency of 2022.

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The pound was resilient against the US dollar and has risen to two-month highs. Last week it hit a 22-month high against the euro as the potential for more hikes by the Bank of England (BoE) offered support. Omicron concerns have eaten away at some of the pound’s gains against the euro.

The prospect of a BoE interest rate hike at the Bank’s February meeting has helped boost market expectations.

UK Prime Minister looking to reduce quarantine period

British Prime Minister Boris Johnson said on Monday that the government is considering the prospect of reducing the quarantine period from seven to five days. Since Britain was making progress against the variant, the government will look at reducing the days of isolation, but it warned that the number of hospitalised people was rising. The Prime Minister explained that "We've got to make sure that we see off Omicron. We're making great progress. (But) the 18,000 people with COVID currently in hospital... that's massively up, and the numbers are increasing.”

His comments did not have a noticeable impact on the pound.

UK companies remain optimistic

The latest survey from accountancy company Deloitte has showed that 37% of chief financial officers are planning to boost investment in 2022 and focus on growth despite Omicron concerns. Companies expect conditions and productivity to improve but persistent labour shortages remain a considerable risk. A high number of companies believe that trade conditions have been affected by Brexit.         

Brexit concerns

Manufacturers have warned that Brexit will exacerbate costs amid concerns of persistent challenges relating to customs delays and red tape. Make UK, which represents 20,000 manufacturing firms across the UK has said that Brexit remains a central concern. In its 2022 Make UK/PwC senior executive survey of 228 firms, businesses have warned of damage from Brexit disruption which has been further complicated by the pandemic and rising costs.

GBP/EUR hits a 22-month high

Last week’s positive market sentiment favoured risk sensitive currencies such as the pound and pushed the euro lower. The euro was also lower due to the significant differences in policies by the UK and European central banks. Eurozone data did not help offer any support.

The pound rose further following the UK government’s decision not to introduce more Covid restrictions while BoE rate hike expectations boosted Sterling. Traders have now priced in an 82.5% chance of another interest rate rise at the bank’s meeting in February.

However, the rising number of Covid cases puts further pressure on the pound which has failed to sustain its 22-month high.

Week ahead: What to expect

Omicron will continue to impact on the British currency. If Covid cases continue to fall, then the pound will strengthen and vice versa.  

On Friday, we get the latest GDP data, which is expected to have grown 0.4% in November and may help offer support to the pound.

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The pound started the new year strong as it rose against the US dollar on Tuesday and Wednesday. Analysts say that the strengthening is due to investor optimism about the effects of the Omicron variant of Covid-19 which has been less disruptive to the economy than originally expected. Investors are also optimistic about a potential Bank of England interest rate rise as early as next month.

On Thursday, the pound was lower as the US dollar strengthened following the Fed meeting minutes which showed that the Bank was more hawkish than expected. These has created concerns about faster than expected tightening of the Fed’s monetary policy which along with rising inflation will require the Bank to act and raise rates sooner than expected.

Services PMI data was higher than the preliminary reading, but it showed that the UK services sector lost momentum last month due to the lockdown, with the hospitality and travel sectors being affected the most.

Omicron restrictions ease

While the Omicron variant has affected a high number of UK citizens, the Prime Minister Boris Johnson avoided stricter lockdown measures and on Wednesday he announced that a pre-departure test was not needed when travelling to England.

Markets also appear to have decided that Omicron concerns are over, and investors are now focussing on the prospect of wider global reflation. Reflation refers to attempts to bring the economy back up to the long-term trend following a dip by increasing the money supply or by reducing taxes. The pound is considered to be a "pro-reflation" currency, according to analysts.

For the markets, the prospect of further restrictions is very low considering that the government is against such measures.

Bank of England rates

Markets are expecting further interest rate hikes from the Bank of England, as they have already priced in 100bp of rate hikes in the next 12 months.

With the Bank demonstrating that is willing to raise rates despite Omicron concerns and additional political support for the November rate hike from Chancellor Rishi Sunak, markets are optimistic.

Currency markets are pricing in two rate rises by the Bank’s March meeting and a full percentage point by the end of the year.

The Bank raised interest rates for the first time in three years in December, despite the Omicron variant and at a time where thousands of people were forced to self-isolate. Financial markets expect a second interest rate rise from the Bank in February from 0.25pc to 0.5pc.

Despite market optimism, economists have warned that household savings are falling as higher prices are eating into budgets. At the same time, lenders are said to have the ability to lend and mortgage rates are expected to be competitive in the near future.

In the meantime, Andrew Sentance, who was a member of the Monetary Policy Committee between 2006 and 2011, intends to push for an investigation into the Bank of England’s role in raising rates and he will write to the chairman of the Treasury Select Committee and former Cabinet Minister Mel Stride this month. He criticised the BoE for being “dormant” and reluctant to take action.

 

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Sterling has started the new week lower as Omicron fears have gripped markets. The threat of new lockdowns has rattled markets across the world with all risk sensitive currencies, such as the pound, falling. With reduced central bank support and the ongoing pandemic, investors want to avoid unnecessary risks ahead of the Christmas period.

Global stock markets were also lower partly due to news that President Joe Biden's Build Back Better package did not pass the Senate. Safe-haven currencies such as the yen, US dollar and the Swiss Franc rose as risk-off sentiment turned investors to less risky assets. As it is commonly noted, the pound was lower against the euro which seems to benefit when global markets are down.

Sterling was however higher against commodity currencies such as the Australian and New Zealand dollars.

Risk aversion in global markets

Lockdown risks are rising in the UK as Health Secretary Sajid Javid has not ruled out stricter measures before Christmas after health advisers suggested that more restrictions were necessary to control the rising number of coronavirus infections. Countries such as The Netherlands will enter a full lockdown until at least the 14th of January, while various European countries are considering more restrictions to fight the spread of the virus. Reports suggest that tighter restrictions are expected to be introduced in Germany too.

The recent decline of the pound was driven by a risk aversion mood in global markets due to Omicron. The pound fell as is one of the risk sensitive currencies that falls when global markets seek to avoid risk and traders put their wagers on safe-haven currencies. For financial markets, especially foreign exchange markets, Omicron’s impact on the economy is considerable, and it could reverberate into the new year. Traders are concerned about Omicron’s effects on global growth at a time when central banks are focused on withdrawing support, including the Federal Reserve which will proceed to withdraw stimulus over the coming months.

Inflationary pressures

The introduction of new restrictions comes at a time where inflationary pressures persist, with the global economy struggling to return to pre-pandemic levels following 2020’s restrictions.

According to analysts, financial support programmes to mitigate against pandemic measures will become more costly, and central banks would want to avoid them.

Global growth risks have increased, as President Joe Biden's Build Back Better stimulus package has failed to pass, after Senator Joe Manchin said he cannot vote for the $1.75 trillion package as it will increase the country’s debt and push inflation higher. Americans are already struggling with high inflation taxes and utility bills.

The removal of accommodative monetary policy by many major central banks will affect risk assets and emerging markets, as many developing market currencies have weakened the last six months.

The pound will strengthen if risk sentiment improves, but, at the moment, due to the ongoing pandemic, uncertainty will continue.

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The pound has weakened due to the new Covid restrictions, and it could fall further, analysts have said. It failed to retain its momentum as the latest coronavirus headlines have put more pressure on the British currency.

Health Secretary Sajid Javid said that the Omicron variant is spreading at a "phenomenal rate" in England, but no Omicron-related deaths have been confirmed yet.

Covid threat is raised to Level 4

On Sunday, British Prime Minister Boris Johnson warned that the UK faces the Omicron "tidal wave" and he vouched that all eligible adults in England will receive the booster dose by the 31st of December. Downing Street explained that without the protection of a third dose, NHS beds would "quickly fill up and the long term damage to the economy and the NHS efforts to bring down the backlog will be even greater." The UK has now raised the Covid threat to “Level 4”, which is one level below the maximum.

Nicola Sturgeon also said on Sunday that the Scottish government will ensure that all adults have access to a booster dose by the end of the year, while Mark Drakeford said the Welsh government will try to accelerate its vaccination program.

3,137 Omicron cases have been reported in the UK on Sunday, which marks a rise of over a thousand since the previous day.

The pound could find it difficult to regain its footing as investors are evaluating the potential effect of the Omicron variant on the Bank of England's (BoE) policy decisions, which will be announced later this Thursday.

Plan B and Bank of England

The announcement of the government’s “Plan B” restriction measures to fight the spread of the Omicron virus was quickly followed by news that a so-called “Plan C” may soon follow, which will have a huge impact on the UK economy and currency as it adds to the uncertainty and potential delays of an interest rate hike by the Bank of England. 

According to analysts, BoE policymakers have already noted that the UK economy has likely met the requirements for an interest rate rise, but the Omicron variant adds significant uncertainty to the economic outlook and will likely mean that a rate hike will be delayed until February.

It’s possible that this week the BoE will leave the Bank Rate at 0.10% and that will push the pound lower. However, since markets are already expecting the bank to keep interest rates unchanged, the effect on the British currency will be limited.

The decision on whether to raise interest rates next week will very much depend on the current uncertainties about the health and economic impact of the Omicron wave, so the Bank is expected to keep a more cautious attitude and wait for more information before deciding to increase the cost of borrowing.

The pound is also expected to remain vulnerable ahead of the latest European Central Bank (ECB) meeting, which could allow the euro to strengthen further. The ECB is expected to announce an increase of its monthly bond purchases as part of its quantitative easing programme called Asset Purchase Facility (APP). However, the ECB could delay this decision due to the current uncertainties.

While expectations have been lowered, and February is most likely the time that the Bank of England might decide to lift interest rates, any surprise decision to lift the rate this week would provide a considerable boost to the currency.

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The pound has fallen against the euro as the market continued to avoid risk currencies in favour of safe-havens. On the other hand, the pound has gained support against the US dollar and reversed some of its losses from Friday following positive Brexit-related news. The UK has granted new licences for French ships to be able to work in British waters which was seen as a sign of progress and offered a moderate rise to the British pound. Apart from this, the broader market risk sentiment will influence demand for the dollar and set the tone for the pound.

Bank of England

A potential risk to the pound is the possibility of the Bank of England (BoE) postponing an interest rate hike on the 16th of December. BoE Monetary Policy Committee member Michael Saunders noted that the new Covid-19 variant has clouded the economic outlook and created uncertainty. Saunders clarified that it is beneficial to wait for more information before tightening monetary policy.

Omicron

Sterling fell against the single currency due to uncertainty regarding the new variant. The spread of the virus in South Africa suggests that this variant has higher transmissibility and affects immunity more significantly than other variants such as the Delta one. South Africa has reported an increase of 11,125 new Covid cases a day, on Sunday, which are less compared to previous days.

The Omicron variant has been found in more than 16 US states, and more cases are expected to be detected, according to Dr Rochelle Walensky of the US Centres for Disease Control and Prevention. Many of the cases were among fully vaccinated individuals who had mild symptoms, although it was not clear whether these individuals have had the booster. The Delta variant accounts for 99.9% of new Covid cases in the United States, Walensky added.

The emergence of such a variant threatens to disrupt efforts to end the pandemic. The World Health Organisation said that the Omicron variant will possibly spread internationally and poses a very high risk of infection that could have a very negative impact on certain places.

The coronavirus pandemic is not over and the next one could be even worse, the creator of the Oxford/AstraZeneca vaccine noted. Professor Dame Sarah Gilbert warned that while “this pandemic is not done with us”, the next one could be even more lethal.

With considerable uncertainty and lack of more information on how fast Omicron can spread globally, markets will remain volatile.

Pound: week ahead

The week ahead could be significant depending on how the market reacts  to new details about the threat of the virus. October’s UK GDP data due out on Friday morning will also provide a clearer view of the UK’s economic recovery in the final quarter. Friday’s GDP data is expected to show 0.3% pace of growth for October, an expansion driven by the services sector, which is now threatened by the virus.

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The pound has been lifted from its lows after the Bank of England disappointed markets by keeping interest rates unchanged. On Tuesday, the pound was higher as investors are now focusing on a February rate rise.

While speaking at a virtual event organised by the Bank of England (BoE), Governor Andrew Bailey stressed that they will have to act and raise rates if they see a clear indication that higher inflation is feeding into wages. His comments did not impact on the market pricing of a rate hike in December. The CME Group's BoE Watch Tool shows a 67.5% chance of a 20-basis points rate hike before the end of the year.

In terms of Brexit, the ball is now in the UK’s court. After the EU clarified that they will act accordingly if Britain were to trigger Article 16, they are now waiting for the UK to make the next move.

Economic growth and Bank of England

The Bank of England’s dovish turn and less aggressive policy is in line with market data and suggests that their interest rate decision was made based on a more restrained and conservative economic growth outlook. The Bank lowered its 2021 growth forecast to 6.7% from August’s 8.5% forecast but raised the 2022 GDP forecast from 2.3% to 2.9%. 2023's forecast has been lowered to 1.1% from 1.3% that it was previously.

Inflation

Inflation is expected to go over the 2.0% target in the coming months and the Bank could act by raising interest rates if it deems appropriate. Bank of England Chief Economist Huw Pill said on Friday Nov. 05 that he believes the pace of wage inflation will surpass both those of the Eurozone and the US.

A more measured Bank means that there are less risks for early tightening, especially if inflation proves to be transitory. This will also support economic growth and households which are already struggling with higher costs.

Economists do believe that the Bank of England will still raise interest rates to fight inflation in the near future, as they expect hikes in December and February.

Other possible factors to consider for pound volatility

  • As a procyclical currency, the pound goes up when global stock markets are strong and falls when they fall. If the pound weakens it is usually against stronger safe havens such as the US dollar, the yen and the franc. For now, market sentiment is positive, and this has given fresh impetus to the pound.
  • Brexit tensions are growing, and this could potentially impact the pound. Ireland’s foreign minister Simon Coveney warned that the EU-UK Trade and Cooperation Agreement could be dismissed if the UK triggers Article 16 and rewrite the protocol on Northern Ireland. The protocol, which is part of the EU-UK withdrawal agreement, was agreed in order to avoid a north-south trade border on the island of Ireland. Protestant Unionist parties have rejected the agreement, and two buses were set on fire in the past week. If the UK fails to maintain a border in the Irish Sea, then this will threaten Ireland’s economic rights as an EU member and it will be unacceptable by the 26 EU member states. Without a border, animal and plant products will enter the EU single market, without full legal controls. Ireland’s goods won’t be trusted, and checks will possibly be required in order to enter the EU. Markets will await any updates on Friday, following the EU and UK's chief negotiators meeting this week.

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The pound rose on Tuesday against both the euro and the US dollar, as stock markets increased, and expectations for an early November rate hike by the Bank of England remained strong. This is the highest level since the pandemic started in March 2020. If the Bank of England proceeds to an early rate hike, then markets will not be disappointed and the pound will rise further, as many analysts suggested. However, if it strikes a more cautious tone and reduces expectations for further rate hikes in 2022, then the pound could fall.

A hawkish statement by the Bank of England suggesting a faster cycle of hikes than is currently expected might boost the pound further, but this is not anticipated.

Interest rates

If the Bank of England raises interest rates as soon as the 4th of November, then the UK central bank will be the first major central bank to raise rates ahead even of the European Central Bank (ECB). The pound rose against the dollar, but the gains were not substantial as the US Federal Reserve is on target to raise interest rates in 2022 with the November policy meeting likely to confirm this.

The lower number of Covid-19 cases has helped boost market sentiment and has given the Bank of England further evidence that the economy has the potential to grow as we come to the end of the year.

Current and potential obstacles

However, Britain's weak economic data, such as Friday's unexpected drop in retail sales has capped further gains. UK growth momentum is also weakening. There are also concerns about potential tax hikes that could be announced on Wednesday's budget statement, alongside tensions between the EU and the UK post-Brexit provisions relating to the trade between Britain, Northern Ireland, and the European Union member Ireland.

A possible headwind for the pound is the failure of the negotiations between the two sides over the Northern Ireland protocol, as Britain has threatened to take unilateral action if talks fail. #

Rishi Sunak’s budget announcement on Wednesday

Traders are now awaiting finance minister Rishi Sunak's budget statement on Wednesday. Markets might be already aware of his plans for higher corporation tax and national insurance contributions, but the devil is in the details. He is expected to end the public sector pay freeze for millions of workers and there has been speculation that the minimum wage for those aged 25-plus could increase from £8.91 an hour to £10 before the next election. For the NHS, there have also been announcements for a £5.9bn for NHS backlogs, diagnostic services and elective surgeries funding, while a £2.1bn is going to improve IT across the NHS. Another commitment has been for £5bn on health research and development over three years. A total of £850m has been promised to inject new life into the arts as a “post-pandemic funding boost.” £700m has been promised to be spent on the new post-Brexit borders and immigration system, and a new maritime patrol fleet. Among his other pledges, is a six-month extension to the COVID recovery loan scheme to June 2022.

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UK inflation has fallen slightly but remains above the Bank of England’s target. According to data from the Office for National Statistics (ONS), UK CPI inflation eased slightly to 3.1% in September, from 3.2% in August—the highest in nine years.

The pound softened on Wednesday morning following the inflation data, as analysts expected the September reading to remain at 3.2%.

The slowdown is mostly due to the effects of lower prices of dining out last month compared to last September, when prices rose following the end of the Eat Out to Help Out scheme.

BoE

The data comes after Bank of England Governor Andrew Bailey said that the central bank will have to act to ease inflationary pressures – raising expectations for earlier rate hikes. According to economists, the bank’s task is a difficult one, as it expects inflation to reach 4% in the current quarter, with higher interest rates expected to ease it. However, the economy is struggling with higher costs and rising commodity prices, which interest rates have no power over.

Inflationary pressures rise

The cost of UK company goods and services continued to rise last month, affected by the supply chain crisis. Output price inflation rose to 6.7% per year in September, from 6% in August. Inflationary pressures are building in the economy as producers increased their prices, passing on costs to consumers. Companies reported that input prices increased by 11.4% year-on-year in September. Manufacturers faced commodity costs and transport costs due to shipping issues and a shortage in lorry drivers.

Economists: inflation is temporary

Economists are warning that September’s fall in inflation will be temporary. Costs rose due to supply issues and the higher energy price cap. The persistent supply-chain disruptions and energy price effects could push inflation higher above 4% early next year.

Senior economist at Royal London Asset Management Melanie Baker, expects more inflation. He warned that energy bills could push consumer price inflation further, which will reduce real income growth for many and add to some of the economic challenges in 2022.

Paul Dales of Capital Economics predicts inflation to reach 5% next April, when Ofgem hikes the energy price cap again. He noted: “However, this feels a bit like the lull before the storm as the 12% rise in utility prices on 1st October will probably lift CPI inflation to around 3.8% in October. And we think inflation could then climb to around 5.0% in April next year due to a further rise in utility prices and the upward influence from global/domestic product shortages. With underlying wage growth and inflation expectations rising, the BoE is concerned that higher inflation will become embedded in the system. That’s why it become much keener to raise interest rates.”

Dales explained that he doesn’t expect interest rates to be raised as far as 1.00% by the end of next year, since higher inflation will weaken the outlook for activity and with supply shortages easing, inflation will eventually fall to around 2% by the end of next year.

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Sterling reached a 20-month high against the euro on Monday after Bank of England Governor Andrew Bailey sent another signal that the central bank is heading towards raising interest rates as inflation risks rise. On Tuesday, the British currency held on to its near 20-month high gains against the euro and has reached a new one-month high against the US dollar. The main factor supporting the pound is expectations the BoE will raise rates, with investors speculating on a rise to 0.25% by December, or even earlier by November. Traders will be focusing on the release of the UK CPI inflation data for September on Wednesday and Friday’s PMI data for further clues.

Despite the pound’s excellent performance, some foreign exchange analysts are wondering whether the recent gains can be sustained in the long term.  

Warnings

Many economists and analysts have warned that the Bank of England’s intention to return interest rates to pre-pandemic levels could be a huge mistake that will impact on economic growth and push costs higher for households that are already under pressure. Higher interest rates, combined with zero growth and high inflation will hurt both the economy and the pound.

Others have noted that the pound won’t be supported for a long time by the Bank of England’s higher interest rates due to persisting supply chain issues and a struggling labour market.

Former Bank of England Monetary Policy Committee Member, David Blanchflower, said that raising rates very soon will be a disaster and “foolish.” He told BBC Radio 4 that interest rates are at 0.1% but economists warn that inflation could peak at 6.0%. Former MPC member Andrew Sentance laughed at Danny Blanchflower’s comments saying that he did not understand monetary policy.  With economists being torn about the prospect of higher interest rates, it is not surprising that there are so many differing views. However, markets have priced in a rate hike and expectations remain solid that an interest rate hike is possible in November.

Bank of England has been Misunderstood?

At the same time, analysts argue that the BoE Governor’s recent comments have been misunderstood and that a November rate rise is unlikely. Bailey has stated that the Bank will act if there are inflation risks in the medium-term and that the Monetary Policy Committee will wait and see until December when labour market data is available.

Also, for some analysts, the subsequent rate hikes being priced in by investors are a bit extreme as possibly two rates maximum by the end of 2022 sounds more reasonable. However, any recent hike expectations being priced out could also negatively impact on the pound.

Others have argued that, if indeed early interest rate hikes will be disastrous to the economy, then pricing out these rate hikes will possibly support the pound.  With so many different arguments, it is not yet clear how the pound will react. Some commentators have even gone as far as to suggest that the pound will fall whatever happens. For example, if the BoE ends up being more dovish and does not raise interest rates, it will end up disappointing markets. On the other hand, if it does deliver early rate hikes it might end up making a policy mistake. Nonetheless, Friday’s PMI data might offer further guidance: if it comes stronger than expected then the pound will strengthen and so will the case for raising interest rates.

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