The pound is expected to remain supported by market expectations of further interest rate hikes, according to analysts. The prospect of a much stronger euro is although questionable, as it is believed that the euro rally following last week's European Central Bank comments has possibly run out of steam.

The pound rallied against the euro and reached its highest level in two years last Thursday after the Bank of England raised interest rates, but those gains were soon erased by the Governor Andrew Bailey’s cautious tone and warnings about slowing domestic growth.

Sterling to remain supported

However, analysts have stressed that the Bank’s determination to hike rates to control inflation and the fact that it has overdelivered in the last two meetings, should keep further rate expectations high and sterling supported. Barclays forecast that the Bank will hike 25bp back-to-back in both March and May. Barclays also expect the pound to strengthen against the US dollar but drop against the euro by mid-2022.

It has also been argued by analysts that there are some factors that offer support to Sterling and suggest the economic outlook is not that negative. Paul Robson, Head of G10 FX Strategy, EMEA, at NatWest Market has mentioned that the January UK PMIs indicate a decent pick-up in activity in the last week of January, while the government’s announcement of fiscal measures will help to balance the cost-of-living rise. He also added that the removal of travel restrictions could support sectors of the economy that have been hit by the pandemic.

Concerns about the pound outlook

Analysts remain cautious about the pound’s appreciation and note that its gains might be limited due to the adverse economic background against which the BoE is tightening its monetary policy.

Additionally, the Bank’s hiking cycle is now fully price in by markets and any unexpected changes and disappointment could result in pound weakness.

ECB and interest rate hikes

Analysts have also pointed out that the market might be already pricing in too many interest rate hikes from the ECB. When last week the ECB said all members of the governing council were concerned about Eurozone inflation, markets understood that it might change its policy and start tightening monetary policy like other central banks. The market now expects two hikes, but for rates to be hiked in 2022, then the tapering of quantitative easing will have to accelerate, especially since  ECB President Christine Lagarde is resolute that the normal sequence of QE and then rate hikes will be followed.

Barclays have said that they now expect a March announcement of a faster tapering of asset purchase and 25bp rate hikes in both March and September 2023. Markets now expect the ECB to hike and tighten monetary policy much earlier than expected and closer to the US Federal Reserve and Bank of England. This scenario will be supportive of the euro.

On Monday, ECB President Christine Lagarde emphasised that Eurozone inflation risks are on the rise, but price pressures could still recede. She said: “Demand conditions in the euro area do not show the same signs of overheating that can be observed in other major economies.” She added: “This increases the likelihood that the current price pressures will subside before becoming entrenched, enabling us to deliver on our 2% target over the medium term.” Markets now price 50 basis points of rate hikes for 2022, but economists are more careful, with most forecasting the first one at the end of the year or early 2023. Of course, markets will gain more clarity as we move closer to the ECB's March policy meeting.

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