Sterling is Facing Headwinds in January 2022 Despite a Strong End to 2021

Sterling is Facing Headwinds in January 2022 Despite a Strong End to 2021

 Published: January 5th, 2022

The pound (GBP) was one of the top-performing majors in the last trading week of 2021, but the new year might not bring glad tidings for sterling bulls. Some analysts say that economic risks might prompt traders to re-think their long-held assumptions about looming central bank policy decisions.

GBP touched higher amongst G10 peers in the seven days leading up to 23rd December, with investors’ risk appetite impacting the Australian, Canadian, and New Zealand Dollars. The GBP/EUR exchange rate came within a whisker of 1.18, having been lifted through much of December by economic numbers that suggested inflation was surging.

Bank of England (BoE) policymakers agreed to raise the bank rate from 0.10 per cent to 0.25 per cent after inflation exceeded five per cent in November, more than double the forecast rate.

In a market analysis, Rabobank's FX strategy unit said that investors had factored in too many central rate rises for 2022. 'We believe these will be scaled back to some extent in the coming months, which may weigh further on the pound. It's our view that EUR/GBP will nudge upward towards 0.86 over the course of 2022.'

The BoE's late December rate rise came with a comment that's prompted some traders to bet more heavily on at least three bank rate rises in 2022.

When the coronavirus outbreak began in 2020, the Bank of England's bank rate was cut from 0.75 per cent to 0.10 per cent, a new all-time low. December's rate rise seemed to signal the first in a series of measures designed to normalise policy.

However, Rabobank and others now see Threadneedle Street’s monetary timeline for policy normalisation as less certain. Domestic politics and a shifting pandemic picture could have possible consequences for the pound over the coming months.

Pandemic disruption and political intrigues

'While Prime Minister Boris Johnson is resisting calls for tougher measures after announcing the COVID 'Plan B' earlier in December, many public events have been cancelled, and the hospitality sector is suffering as people stay at home,' said Rabobank's analysis.

The Omicron variant of COVID-19 and Westminster’s response to it suggests the pound will face initial headwinds as the UK economy transitions into the new year. Political uncertainty could also cloud the picture as 2022 gets underway.

An investor note from BMO Capital Markets currency unit noted the possibility of a leadership challenge within the Conservative party this year. Still, it said the risk of a snap election is very small. Other political uncertainties could rear their head later in the year.

‘The potential for a second Scottish independence referendum might hold back GBP gains in the second half of the year.’

BMO believes a combination of coronavirus and political risk could slow economic momentum, blurring the outlook sufficiently for traders to question the prevalent assumption that Bank of England policymakers are eager to raise the bank rate again in February 2022.

GBP keeps up its momentum, for now

Despite those concerns, the pound's 2021 run continued as markets got underway on Tuesday, 4th January. GBP reached a new two-year high against the euro as traders returned to their desks in Frankfurt and London, seemingly eager to make a bullish start to 2022.

Historically, sterling tends to do well when global stocks rally and market sentiment is supportive. That mix of conditions has led to further advances this week.

‘The pound is a classic risk-on currency that performs best when stock markets are on the up,’ said UBS’ head of currency strategy, Thomas Pirelli, in an interview with the Financial Times.

The pound to euro exchange rate rose to 1.1961, a level that was last seen in March of 2020. That took retail rates for international payments to north of the 1.19 threshold. Pirelli says the next critical threshold to watch will be 1.2073, the post-Brexit high also achieved in March 2020.

‘While the round number of 1.20 looks achievable, it could prove to be the ceiling in the near-term for the recent rally. A significant number of large euro positions are expected to be triggered’.

UBS analysts believe investors are now bidding commodities, equities, and Sterling as a sense begins to take hold that the worst of the Omicron wave is imminent and that further restrictions on commercial activity won't be needed.

That could free up a phase of economic expansion in the first half of this year as business and consumer confidence rebuilds post-pandemic. Central banks could also provide a boost to investor sentiment in the first half of the year.

Is 2022 the year that QE tapering will take hold?

While some investors act on assumptions that 2022 to be the year central banks start reducing economic and monetary stimulus, the European Central Bank and US Fed are expected to continue with expansionary monetary policy until the middle of the year, creating supportive conditions for the pound.

Currency market analysts at Barclays said in an investor note that evidence that Omicron causes less severe forms of illness has sent a wave of relief into markets.

'The path for currencies and equities in 2022 won't be smooth, but the strong start GBP is seeing this week could continue for some weeks yet. With the massive inflows we saw into risk assets in 2021, plus the significant inflexion point being reached by most G10 central banks, we now see a risk of bigger corrections in the future.'

Barclays thinks those corrections will be increasingly relevant if central banks begin ratcheting back stimulus programmes.

'In the near-term, the moderate pace of tightening and high levels of monetary accommodation suggest that risk assets may be more resilient.'

Barclay's analysts expect to see more record-highs for the S&P in 2022. The index rallied on 3rd January to a new all-time high, while European and Asian markets also climbed upwards to new peaks.

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