The pound has fallen to three-week lows against the US dollar due to UK political concerns and the deepening risk-off mood. It has started to recover some of its losses and could rise higher if global market sentiment improves.

With geopolitical tensions rising between Russia and Ukraine and NATO sending reinforcements to eastern Europe, markets are worried, while safe-haven US dollar has strengthened as a result.

Ukraine – Russia tensions

Around 8,500 US troops are ready for a possible deployment to Eastern Europe as Russian troops concentrate on Ukraine's border. US Secretary of Defence Lloyd Austin issued the prepare to deploy orders following the direction of President Joe Biden, as the US gets ready for a potential Russian invasion of Ukraine.

The goal of sending military reinforcements to Eastern Europe is not to take part in any combat but to reassure allies and provide deterrence.

NATO allies have also put forces on standby as the Ukraine crisis escalates. Biden held a video call with European leaders on Monday afternoon in response to Russia's aggressive actions in Ukraine.

Following the online meeting with US, France, Germany, Italy, Poland, the United Kingdom and the European Union leaders, NATO Secretary General Jens Stoltenberg said, "We agree that any further aggression by Russia against Ukraine will have severe costs." He added that "NATO will continue to take all necessary measures to protect and defend all Allies, including by reinforcing the eastern part of the Alliance.”

Moscow has denied any plans to invade Ukraine and accused the US and NATO of escalating tensions over their support for Ukraine. The Kremlin on Monday rejected the reports about plans to install a pro-Russian leader in Ukraine as “fake.” Kremlin spokesman Dmitry Peskov said that “Tensions are escalating due to concrete actions taken by the US and NATO.  I mean, the informational hysteria that we are witnessing. It is generously framed by a huge amount of false information, just lies and fakes."

Pound outlook

Further to geopolitical tensions, the pound has also been affected by global market sentiment. Analysts have pointed out that the pound could recover in the short-term if the global stock market retreat comes to an end. Nonetheless, analysts expect 2022 to be a volatile year for investors and this will make it harder for analysts and traders to forecast pound price movements.

Sterling has fallen against the euro and dollar after investors sold stocks and other related risk assets in anticipation of higher US interest rates and tensions on the Ukraine border. The outlook remains volatile as the pound tends to fall against the euro and dollar when stocks are sold. Financial analysts believe that volatility will continue as traders readjust to rising inflation and interest rates.

The Swiss franc, US dollar and Japanese yen have all benefited, while the commodity currencies such as the New Zealand and Australian dollars, the Norwegian krone and emerging market currencies have all posted losses.

The pound could benefit from rising demand for UK assets and when investor capital flows back in the UK.

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The pound fell ahead of the weekend due to fading expectations of a Bank of England interest rate hike and risk off sentiment in global markets. The term “risk off” refers to traders and investors’ sentiment in the financial markets where they tend to reduce their risk exposure and focus on protecting their investments. One of the key concerns for markets is the discovery of a new Covid variant in South Africa that could be more transmissible than previous ones.  

Traders turned to safe-haven currencies such as the US dollar, yen, and Swiss franc instead of riskier assets, such as the Australian dollar, South African rand or emerging market currencies, which were sold.

New Covid-19 variant

The new coronavirus variant in South Africa has created serious concerns as there are fears the country may face a severe fourth wave and that the virus could spread internationally. More and more countries are banning flights from South Africa and neighbouring countries, while the EU has proposed to ban flights from the region. The UK, the Netherlands and Japan have stopped flights from southern African nations including South Africa, Botswana, Namibia, Zimbabwe, Eswatini and Lesotho. The above nations and Mozambique are on the red lists of Singapore, Italy and Israel.

The World Health Organization (WHO) has said it will take a few weeks to determine how transmissible and how big its impact will be, but they are definitely concerned.  100 cases have already been detected in South Africa. The variant, unlike previous ones, is the most heavily mutated version, which means vaccines may not be as effective. The new variant, (B.1.1.529) not yet named, has possibly evolved during a chronic infection of an untreated HIV/AIDS patient, Francois Balloux, director of the UCL Genetics Institute, explained. Immuno-compromised people can harbour the virus for longer, scientists said.

The new variant has driven traders to buy the yen and Swiss franc and it could further boost the US dollar. The pound is low as it is losing against the safe havens but is higher than riskier currencies. The euro has also been preferred instead of the pound, which suggests that investors focus on bigger and more global events.

 What to expect in the currency market?

Markets will keep a close watch on research of the new variant, as scientists strive to understand how vaccines and prior infections can prevent contagion and the beginning of serious illness. Any bad news regarding the new variant and its transmissibility will increase fears about the global spread of the virus and a second cycle of the pandemic.

The pound fell very low against the euro when the pandemic started last year and if the same is repeated with a second cycle, then the pound will suffer losses against safe-haven currencies. On the other hand, it could rise against the Australian, Canadian and New Zealand dollars and emerging market currencies.

If vaccines are proven to protect against this new variant, then markets will become less pessimistic, and could return to levels seen on Thursday 25 November, before the news about the South African variant was announced.

Central banks considering raising interest rates, such as the Bank of England, may reconsider tightening their policy too early due to the new variant uncertainty. If expectations for a December rate hike in the UK decline further, then the pound could lose recent gains.

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Sterling’s major weakness in the near future is a potential weakening in risk sentiment which will also weigh on global stock markets, hitting risk-correlated currencies. According to analysts, global risk sentiment will remain one of the key external drivers of the UK currency. At the same time, if global developments improve and equities stabilise, the pound will still need a boost from domestic factors such as stronger domestic data to recover some of its most recent losses. For the pound to continue to strengthen, the market will need to become convinced that the medium-term growth outlook for the UK economy is improving markedly. This would require some real productivity gains to be realised over the coming months and years.

While UK fundamentals have proven to be supportive, the global picture is very important for Sterling, especially when stock markets suffer, risk sentiment is low, and investors are usually spooked.

Risk appetite in global financial markets

Analysts have noticed a pattern emerging where the pound falls against the euro in times of risk off conditions. The pound commonly benefits from strong global growth, which has also been the case for the euro. When there is limited financial risk, investors tend to take more risks, therefore creating a “risk-on” situation. However, when there is uncertainty and high volatility, what is also called a “risk-off” environment, traders want to avoid risk and they sell their higher-yielding assets and move their funds to safe-haven currencies.

The euro as a risk-off currency

While the euro like the pound has been the beneficiary of positive market sentiment, more recently, this has changed, and it seems that the single currency benefits against the pound when global investor sentiment weakens. What this means, is that the euro has become a risk off currency.

  • Risk off currency

A risk off currency gains when stock markets decline as investors want to avoid risk and sell their risky assets.

  • Cyclical currency

The euro used to be seen as a cyclical currency but is much less now. Cyclical currencies such as the pound and AUD tend to appreciate when global economic growth is expanding, unlike the US dollar, the yen and Franc which are seen as safe havens.

The euro has benefited when stock markets are selling off and it has given the impression that is a safe-haven asset. According to research from HSBC, due to the low interest rate environment in the Eurozone, billions of cheap euros are borrowed, sold and repatriated into euros, creating demand on the currency and “establishing an impression that it is now a 'safe haven' asset during times of market stress.” Head of FX Research at HSBC Paul Mackel explained that this shift in the euro “comes down to the low growth, low rates environment that has become seemingly endemic in the region,” and is “a consequence of the ECB’s quantitative easing programme and shift to negative rates.” Mackel added that "Signs that rates may be lower for even longer could encourage these outflows to continue, or even exacerbate them.”

"For many years, the EUR was seen as a cyclical play, which benefited from strong global growth. However, the last decade or so has seen overseas asset accumulation outstrip inflows from foreign investors. This could start to change the way in which the EUR behaves,” Mackel said.  

Pound-Euro outlook

If you are a business exchanging pounds to euros or vice versa, it is beneficial to understand this dynamic and how risk sentiment and appetite affect the currency pair. For the pound then to appreciate against the euro, there will need to be improvement in global market conditions. If, on the contrary, global growth and markets are at risk, the euro could appreciate. The rapid spread of another Covid variant or any quick move by the Federal Reserve to withdraw its financial support are seen as major risks to the global economy and the pound in particular.

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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.

If you are a business transferring funds overseas, contacting a currency specialist could save you time and money. Get in touch with Universal Partners FX and their dedicated team to discuss the latest market movements ahead of your currency exchange. If you are transferring funds to pay your employees abroad, get in touch with Universal Partners FX to find out how much you can save in your international money transfers. Universal Partners FX can provide invaluable help on efficient risk management and tailored solutions to your business’ transfer needs.