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– The GBP has fallen steadily this week
Bank of England policy decision at 12:00 BST
– Comes amid soaring UK gas prices
– The bank could choose to ignore the spike in inflation

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The pound sterling is the biggest loser among major currencies last week and those hoping for a stronger exchange rate will look to the Bank of England for some support.

The steady decline suggests that investors have taken the view that the Bank will voice concerns about recent economic developments and signal that the bank rate will remain at 0.10% until 2022, disappointing relative to expectations of a rate hike in early 2022.

As this week approached, money market prices suggested that investors were expecting the bank rate to rise from 0.10% to 0.25% in the first quarter of 2022 and to 0.50% in early 2023. .

The way that this positioning changes over the next few days in response to the Bank of England update will likely move the pound as any attempt to push the timeline results in weakness.

The pound is the biggest loser

Above: The pound fell against all major currencies over the past week.

A first signal of intent lies in the way the Bank’s Monetary Policy Committee (MPC) votes on 1) the immediate end of quantitative easing and 2) the increase in interest rates.

It is possible that more than one member will vote to end quantitative easing, but given that the program is due to end in December, more emphasis will be placed on voting to raise rates.

The MPC has been unanimous in voting to keep rates unchanged since they were lowered to crisis lows in 2020, so any vote to raise rates would be a clear first signal that a “hawkish” shift is underway.

“We expect Michael Saunders, who already voted in favor of reducing the target stock of gilts at the last meeting, to maintain his position. activity at the start of the third quarter, ”says Anna Titareva, economist at UBS.

Unanimous votes to keep rates unchanged and a lone dissenter to end quantitative easing early could serve as the pound’s first bearish signal.

Capital Economics Discount Rate Expectations

Image courtesy of Capital Economics.

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The Bank’s assessment of recent economic developments and the tone they set will potentially give the forex markets an additional signal that will impact the sterling exchange rates.

“What the market will watch will be any noticeable change in the tone of the MPC that suggests that a policy tightening is imminent in the coming months. If so, we could see a strong rally in the pound. sterling, after the currency has spent much of the summer trading in a sideways range, ”said Fawad Razaqzada, analyst at ThinkMarkets.

The main risk to any bullish talk for the British pound is that the Bank of England is cautious about a recent rise in UK gas prices, warning that further price hikes for household utilities and businesses will slow the recovery.

Economists and industry experts believe that a third consecutive hike in Ofgem’s price cap should be announced in February due to soaring wholesale gas prices.

“Growth has slowed down markedly, as consumption is likely to suffer another drag due to soaring energy prices in the fall and next winter. This could seriously call into question the Bank’s August projections of a closed output gap by the end of the year, ”said Sanjay Raja, Senior Economist at Deutsche Bank.

soaring gas prices

Above: “UK natural gas prices significantly outperformed their US counterparts in 2021” – Credit Suisse.

The rebound in the UK economy slowed down over the summer and was generally disappointing compared to economists’ expectations, even before the latest gas price shock.

“The BoE’s projection of real GDP growth in 2021 north of 7.0% looks less realistic based on third quarter data available to date,” said Stephen Gallo, head of foreign exchange strategy European at BMO Capital Markets.

HSBC economists have pointed to the string of disappointments in economic activity in the UK, with the HSBC Economic Activity Surprise Index having fallen sharply in recent times.

“Growth momentum is not just weakening, it is slowing more sharply than expected,” said Daragh Maher, head of foreign exchange strategy, US, at HSBC.

UK card spending has already peaked

Above: UK credit card spending data peaked in early June, image courtesy of Morgan Stanley.

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But a gloomy assessment by the Bank of England already seems to be reflected in the current exchange rates of the pound:

The pound-to-euro exchange rate rose from a September 16 high of 1.1763 to 1.1609, the pound-dollar exchange rate rose from a September 14 high of 1.3913 to 1.3616.

The weakness in the British pound ahead of the Bank of England event comes against a backdrop of favorable market positioning opening the door to a market reaction to “sell the rumor, buy the fact”.

“We believe that the BoE wants to leave behind the lowest crisis interest rate and give itself the opportunity to start reducing its debt portfolio,” said a note from the Nordic lender and investment bank SEB.

Taking a “hawkish” stance on the pound sterling, SEB anticipates that the Bank of England will end its quantitative easing program “prematurely” in November.

They forecast a rate hike of 0.15 basis points in May 2022 and another 0.25 basis point at the start of 2023 and again at the end of 2023, bringing the bank rate back to its level of. before the pandemic 0.75%.

“As the market in 2021 rewarded central bank-backed currencies on the verge of moving away from their very loose monetary stimuli, we expect the EUR / GBP to resume its downtrend in anticipation of BOE hikes, ”SEB said.

The pound rally peaked in April

Above: The 2021 Pound Rally ended in April.

SEB finds that one of the reasons for the recent rise in the value of the euro against the pound was a larger rise in euro area money market interest rates compared to UK rates before the decision from the European Central Bank in September.

But, that “turned out to be a bit of a disappointment for the markets, after which the EUR / GBP spread also started to fall again,” SEB said.

EUR / GBP is forecast by SEB to end 2021 at 0.84, resulting in a GBP / EUR rate of 1.19.

The arguments for the Bank to stick to a timeline of ending quantitative easing and starting a rate hike cycle in early 2022 are based on high levels of inflation in the UK.

“The damning public discourse on inflation is becoming increasingly hawkish, as inflation expectations remain poised to move in a short-term direction: up,” said Sanjay Raja, economist at Deutsche Bank.

He says navigating the trade-off between slowing growth and soaring headline inflation will require careful choreography – “and the Bank of England may run out of time to clearly define how it intends to navigate over the years. coming quarters with inflation above 3% year-on-year “.

Inflation skyrockets in the UK

Image courtesy of TD Securities.

Deutsche Bank finds that a 20% increase in Ofgem’s cap in April – when the cap needs to be reassessed – will add around 60 basis points to overall inflation rates.

Capital Economics only anticipates a first rate hike in 2023 – which, if correct, would deal a blow to sterling bulls – but claims that rising inflation and wholesale gas prices and electricity increases the risk that inflation expectations are no longer anchored.

Inflation ‘de-anchoring’ would occur if inflation expectations were raised: in short, expectations of higher inflation lead to higher inflation as businesses and consumers change their behavior.

“Even so, a rate hike anytime soon would likely prove counterproductive,” says Ruth Gregory, senior UK economist at Capital Economics.

They argue that raising interest rates would weaken demand and jeopardize the recovery and worsen the effects of longer-term economic scars.

“We expect a moderately ‘hawkish’ statement and report from the September MPC meeting on Thursday – but only in a general sense, and not a much more ‘hawkish’ outcome than at the August MPR. BMO Capital’s Gallo said.

BMO Capital expects to see a very low probability that the MPC will drop its description of above-target inflation as “transient” or “transient”; terms used to signal that inflation will come down again and therefore why interest rates do not need to be increased.

The bank will seek to avoid any major communication changes in its Thursday update and BMO Capital does not expect any change in tone to shock the currency and interest rate markets.

Gallo notes that the market is broadly positioned for a lower EUR / GBP and has already absorbed expectations of higher interest rates in 2022.

“As such, we believe the risk of a ‘hawkish shock’ for BoE investors this week is low,” said Gallo.

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