Published: October 28th, 2021
The pound jumped in value against all its G10 peers on Tuesday, 26th October, taking gains in parallel with an ongoing trend higher in global stock markets. In this kind of environment, where broad sentiment around equities is positive, sterling traditionally appreciates.
Fueling the supportive backdrop is the expectation that the Bank of England (BoE) may lift interest rates as early as 4th November, placing its timeline months and even years ahead of the European Central Bank (ECB). However, advances against the dollar have been less pronounced since the Fed remains on target to raise interest rates next year.
Confidence in a rate hike from Threadneedle Street is in the offing has been bolstered by indications that the UK’s battle with Covid-19 may have turned a corner, and the winter months may carry on without severe economic disruption.
Currency analysts at Western Union told Reuters that the pound reached a new 2021 high against the euro on Tuesday the 26th, ‘the highest level since the market turmoil created by the pandemic arrived in March 2020. British bond yields, meanwhile, continued their steady rise with the 10-year yield touching north of 30-month highs’.
The GBP/EUR exchange rate hit 1.1897 on 26th October, while the pound to dollar rate pushed above 1.37 again to quote at 1.3720.
BoE Governor Andrew Bailey announced last week that the central bank would need to step in and keep a lid on rising inflationary pressures. As a result, consensus sees a 15 basis point interest rate hike on 4th November.
Should the bank strike a more cautious tone on its outlook and signal a rate rise isn’t forthcoming, sterling’s recent gains could be put at risk.
Some analysts are expecting pushback. NatWest Markets Forex Strategy Unit said in a note to investors that it's stepping back from its longstanding bet on extended GBP/EUR upside, saying there is a real possibility that the BoE defies expectations and signals more caution on rates next week.
‘The pound will only find further support if the Bank of England makes a hawkish statement on rates and signals a more rapid sequence of hikes than the market currently expects. This, however, is not what we’re anticipating.’
The euro finds itself under pressure ahead of this Thursday's (28th October) European Central Bank (ECB) policy meeting, where the bank is widely expected to resist market expectations for a rate rise before year’s end.
Economists at Barclays told Bloomberg that the ECB’s Thursday meeting would likely result in euro weakness.
‘We anticipate more of the same on interest rate policy from Frankfurt this week. There will have to be an acknowledgement that inflation is hotting up. However, the ECB’s dovish instincts mean they’ll try and avoid being pulled into a game of expectations’.
Investors may find this month’s policy meeting more provocative than usual as bank President Christine Lagarde is expected to push back on the growing market belief that 2024 is delaying a first rate rise too long.
EUR rates could be volatile in the aftermath of her comments. Current market pricing suggests investors are looking for a first ECB rate rise in late 2022, believing that rising inflation will force Frankfurt’s hand.
Barclay’s says money markets are also expecting a rate rise of circa 10bp next year and more than 30bp in 2022. HOWEVER, the ECB has been clear that 2024 is the better timing for such a move, believing that the current spike in inflation is a temporary adjustment caused by the return from COVID lockdowns.
If EUR does find support from a re-set in market expectations, Barclay’s believes that could evaporate if the ECB strikes a stridently dovish tone. If the bank allows enough ambiguity for expectations of a pre-2024 rise to persist, the euro could rally.
‘It’s our belief that the European Central Bank will keep on favouring extended monetary accommodation and keep policy rates at their current levels for longer than markets have priced. Expect that to be blended with another sizeable and flexible QE programme next year.’
Research from Nordea Bank indicates that core inflation in the Eurozone may not exceed the ECB's target threshold (2.0% and above) before 2023, essentially in line with the ECB's own forecasts.
That will give the bank policy ammunition to resist the market's current pressure for an earlier move.
In a note accompanying the research, Nordea says Eurozone headline inflation is expected to peak before years end, then decline through the winter months when the Nord Stream 2 gas pipeline begins operations, and increased supply softens European energy prices.
‘The raised inflation expectations consuming currency markets have gathered pace among companies and consumers. These have the potential to drive nominal wage growth and keep inflation close to the inflation target’.
How the ECB acts in relation to other central banks can affect forex market decisions, with traders looking for opportunities based on differentials in approach and their likely impact on economic growth, and therefore on demand for a currency.
Barclays says the ECB stands alone amongst global central banks in staying the course on lower-for-longer rates, with most others looking to normalise as soon as possible.
The Bank of England has provided clear signals that it intends to act soon to start normalising rates. Bank policy makers have expressed worry that the current inflation surge caused by supply chain issues and rising energy prices could become ‘stuck’ elsewhere in the economy.
‘EUR/GBP was on a downward trajectory even before interest rates shifted in favour of Britain. This is probably due to ongoing euro-area weakness, where China growth challenges and energy price worries have hit the region and impacted EUR valuations. Those forces are potent enough to create the possibility that EUR/GBP could sink further to new post-Brexit lows.’