Pound Sterling Recovery

The British Pound is tipped by a number of institutional analysts to remain supported and over time extend higher from the lows it plumbed against the Euro and U.S. Dollar just last week.

The Pound has at the time of writing clawed its way back up into the familiar multi-week ranges it had established against the Euro and Dollar in the April-September period, having briefly slumped to multi-month lows against its two major peers.

“Adverse headlines on various shortages in the UK hit sterling, but we expect a recovery in investor sentiment toward the pound with the Bank of England clearly heading toward tightening next year,” says Gaétan Peroux, Strategist at UBS AG.

The Pound-to-Euro exchange rate has crossed the 1.17 level again while then Pound-to-Dollar exchange rate sits just below 1.36, but Friday’s U.S. jobs report will almost certainly prove the highlight of the week for this pair.

The British Pound was sold heavily against the Euro and Dollar in the previous week alongside global stocks and high yielding assets as investors fretted that inflation was headed higher for a protracted period amidst a global energy crisis.

But the Pound was easily the worst performing of the world’s major currencies by the mid-week session, suggesting there were some UK-specific factors bothering investors and this was not simply a typical ‘high beta’ event for the currency.

A surge in UK gas prices to record highs combined with a run on fuel station forecourts by panicked consumers pointed to a combination of weakening growth and the potential for materially higher inflation; a potently negative cocktail for the economy.

Sterling was nevertheless able to stage a notable recovery into October 01, probably helped the completion of month-end and quarter-end repositioning on global markets.

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“The GBP is probably overreacting to the deepening of the energy and fuel crisis in the UK, and this is overshadowing the hawkish turn the BoE made just last week,” says Roberto Mialich, FX Strategist at UniCredit.

Helping the Pound lift off from its previous week’s lows was the Thursday release of UK GDP data that showed the economy grew more than had been previously assumed during the second quarter.

In fact, such was the scale of the upgrade economists now say the UK economy’s performance is now comparable to those of other G7 countries.

The UK suffered a deeper contraction than many of its peers during the Covid crisis owing to an economy that is heavily reliant on the services sector, but the scale of the rebound means it has recaptured that lost growth.

GDP growth for the second quarter read at 5.5%, higher than the original estimate for growth of 4.8%.

This means the UK’s level of GDP is now 3.3% below where it was pre-pandemic in the fourth quarter of 2019, revised from the previous estimate of 4.4% below.

The developments mean the Bank of England is likely to raise interest rates in early 2022, which is sooner than other other major central banks such as the Federal Reserve and the European Central Bank.

This rates advantage is said by analysts to be a fundamental source of support for Sterling.

“We also continue to believe UK’s attractive investment attributes and longer-term GBP undervaluation will act as a strong anchor for the pound,” says Marek Raczko, a foreign exchange strategist at Barclays.

Economists at Barclays now see 2021 growth at 7.3% having upgraded it 0.9pp following the GDP release. Under their new profile, the UK economy recovers to its pre-pandemic level in the first quarter of 2022, a quarter earlier than previously forecast.

“We expect markets to focus on longer-term fundamentals as a guide for GBP’s trajectory. Last week’s GBP weakness felt at odds with the aggressive repricing higher in UK yields (three hikes priced next year),” says Raczko. “Longer-term GBP undervaluation will act as a strong anchor for the pound.”

UBS strategists say they maintain a clear case for a Sterling rebound against other major G10 currencies in the short term, including the dollar.

They also anticipate continued gains against the euro and the Swiss franc in the medium-to-long term, supported by faster Bank of England tightening via the ending of quantitative easing in December and the raising of interest rates.

“The month of September was punctuated with a change in narrative from both the Bank of England and the Fed – both central bank meetings were interpreted as more hawkish than the market was expecting and as such both short-term and long-term interest rates have jumped higher,” says Shane O’Neill, Head of Interest Rate Trading for Validus Risk Management.

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“GBP rates have moved the most, 10y yields printed over 1% for the first time since the middle of 2019. Inflation expectations continue to dominate the narrative here and look set to be the market driver as we head into Autumn,” says O’Neill.

Should investors remain focussed on the UK rate advantage then the prospect of the Pound extending higher remains alive.

The major headwind for the Pound at this stage is the broader market environment which remains vulnerable to weakness.

The Pound has a ‘high beta’ when compared to the Euro, Dollar, Franc and Yen, meaning it tends to fall against these currencies when global stock markets are falling.

Global markets are now well off their 2021 highs amidst a cocktail of concerns that global growth is slowing, inflation will stay stubbornly high, supply chains will remain choked up and central banks will be boxed into raising interest rates.

So often during the post-pandemic stock market boom the Federal Reserve would reassure investors that it stood ready to keep cheap finance flowing to the U.S. and global economies whenever sentiment deteriorated, but this is no longer the case given the high inflationary environment.

In fact, the risk is that the continuation of quantitative easing and crisis-era rock-bottom interest rates will only fuel inflation.

Global markets are undergoing a readjustment and this creates risks for the Pound against the ‘safe havens’ such as the Dollar, Yen, Euro and Franc but it does offer potential upside against the likes of the Australian and New Zealand Dollars as well as Emerging Market currencies.

“We think that a return to a regime of higher and less stable inflation in many major economies would result in a rise in exchange rate volatility and, over time, the depreciation of the currencies of those countries which experience higher inflation,” says Jonas Goltermann, Senior Markets Economist at Capital Economics.

Goltermann says over longer time horizons countries with relatively high inflation tend to experience depreciation of their nominal exchange rates.

“Among developed economies, we think the US, as well as the UK, Canada, and Australia, are more at risk of sustained higher inflation. This suggests to us that their currencies will weaken in nominal terms relative to the currencies of many European and Asia economies, where we expect inflation to remain subdued,” says Goltermann.

Written by Gary Howes

Source: Pound Sterling Live