The pound was up against the euro on Wednesday, strengthened by higher UK bond yields and expectations of an earlier interest rate hike by the Bank of England. Sterling rose to a three-week high against the euro yesterday, as traders returned their attention to the prospect of interest rate hikes in Britain. The pound was down last week, due to rising inflation concerns, but it has now recovered.

Sterling’s recovery is mainly due to the prospect of the BoE raising interest rates sooner than expected, but analysts have commented that the pound should have risen even higher especially because of the important difference between the European and UK central banks. While the BoE has clearly stated its intention for an earlier rate hike, the European Central Bank has no plans to raise rates soon. Economists have warned that caution should be exercised though, as the pound’s gains might not be long-lived. It is still unclear whether the BoE will proceed to raise interest rates while the UK is facing ongoing supply problems.

Inflation

On Tuesday, British Prime Minister Boris Johnson said inflation fears were baseless. The final reading of the IHS Markit/CIPS composite Purchasing Managers’ Index showed that companies increased prices at the fastest pace on record, following shortages of staff, raw materials and transport.

Brexit

The pound has yet to react on Brexit risks after the UK told the European Union on Monday it would  “trigger safeguard measures in their divorce deal if the bloc failed to agree to changes to smooth trade with Northern Ireland.” Speaking at the Conservatives' annual conference in Manchester, Brexit minister David Frost stated that "Without an agreed solution soon, we will need to act, using the Article 16 safeguard mechanism, to address the impact the protocol is having on Northern Ireland." The EU is putting together a package of measures to ease the passage of goods from Britain to Northern Ireland, using flexibilities in the protocol, which will announce next week.

Tighter policy could weaken pound

Goldman Sachs Asset Management has said that tighter policy could weaken Sterling. The firm’s strategist for the global fixed income team said that high inflation and energy prices, and Brexit implications could further complicate the inflation outlook. Fears of higher inflation combined with the ongoing supply-chain crisis and an end to the government’s furlough program have worried investors who believe the BoE may choose to raise interest rates sooner than necessary, risking economic recovery.

Other firms and financial analysts are less concerned as challenges are not seen as dangerous and are merely transitory. They don’t believe that the Bank will be forced into a dangerously fast pace of tightening.

What to watch

A key indicator to watch is the UK's labour market as unemployment is expected to increase in October since the government's job support scheme ended on the 30th of September and furloughed staff might not be able to return to their old jobs. The furlough scheme which started in March 2020, supported 11.6 million jobs across the UK and government figures suggest that around a million people were still on furlough when it ended.

If unemployment is lower than expectations, the consensus is that the Bank could move towards a rate hike as a strong labour market will increase the potential for wage rises which push inflation higher.

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The pound is expected to stabilise and rise further according to analysts as investor sentiment is strengthened and the Bank of England is moving toward tightening its policy next year.

The pound stabilised against the euro but remains to be seen how well it will perform against the dollar as Friday’s jobs report will determine the outcome.

Pound is in recovery mode now

The pound dropped last week after concerned investors sold Sterling against the euro and the US dollar fearing higher inflation following the global energy crisis. Higher gas prices and panic-buying at petrol stations due to a shortage of lorry drivers, signalled weakening economic growth and hurt market sentiment. By the beginning of the new month, however, Sterling managed to recover, as analysts noted that perhaps the currency overreacted to the fuel crisis in the UK.

The pound rose, leaving behind last week’s losses boosted by Thursday’s release of UK GDP data that showed the economy grew more than expected in the second quarter. This will also offer more evidence that the economy is growing, and the Bank of England is on track to raise interest rates in early 2022.

Sterling is a good buy

Analysts believe that due to its long-term undervaluation, the pound is an attractive investment. In general, economists believe that economic growth will continue, and the economy will return to its pre-pandemic levels in the first quarter of 2022, earlier than anticipated.

Many currency strategists believe that the pound will also strengthen against other major G10 currencies in the short term and even for longer against the euro. The Bank’s earlier raising of interest rates and policy tightening will prove to be fundamental to the British currency’s performance.

If investors find the currency appealing due to its rate, then this will offer further support to the currency. However, global developments that could influence the pound remain a constant risk for Sterling. As we have noted in the past, the pound is sensitive to global economic sentiment and tends to depreciate when global stock markets fall. With concerns about global economic growth weakening and inflation rising, it is not unsurprising if the pound reacts with more volatility.

Higher inflation remains a constant risk for the pound

Economists said that higher inflation in major economies will lead to the gradual depreciation of those countries’ currencies. For example, the US and the UK, along with Canada and Australia are at risk of prolonged higher inflation, which might weaken their currencies compared to other countries in Asia or Europe where inflation remains within normal levels. Talking on Tuesday during an interview, Prime Minister Boris Johnson, said that inflationary pressures will subside as supply increases. He stated: “What you are seeing is demand, growing demand sucking in gas from Russia or wherever, you are seeing demand for lorry drivers globally and that has an inflationary effect and as that clears, as supply meets demand then inflation abates."

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.