The pound is poised for a bad end to the year, according to Capital Economics

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The pound will remain under pressure for the rest of 2022 as the Bank of England fails to meet rising expectations placed on it by investors, according to new analysis from independent research consultancy Capital. Economics.

Market data shows investors now expect the Bank to ‘outperform’ all other major central banks over the remainder of 2022, including the US Federal Reserve, and Capital Economics says a reversal of those expectations could have downward implications for the British currency.

“We believe the Bank of England will raise interest rates less than current money market discount rates, which in turn should keep the pound under pressure,” said Kieran Tompkins, associate economist. at Capital Economics.

While inflationary pressures are receding elsewhere, they are rising in the UK and bond markets have reacted accordingly by rising.

The yield paid on ten-year gilts rose about 25 basis points after the midweek inflation data, while the yield paid on two-year bonds rose about 40 basis points.

Rising yields are often associated with a stronger currency, with international investors buying assets offering increased returns. “But it didn’t affect the pound,” Tompkins says.


Image courtesy of Capital Economics.


Capital Economics expects the pound to remain under pressure for the remainder of 2022 due to recent developments and market dynamics which include a reluctance to react to rising yields.

The exchange rate between the Pound and the Euro remains supported around its 100-day moving average near 1.1850, a performance that reflects the skeptical market outlook for the Eurozone and the UK.

But it is the exchange rate between the pound and the dollar which should bear the brunt of the market’s disappointment, according to Capital Economics.


GBP/EUR and GBP/USD

Above: GBP/EUR (top) and GBP/USD (bottom) at daily intervals. Set your exchange rate alert here.


According to money market data, the Bank of England needs to rise more than any other G10 central bank over the remainder of 2022 if it is to meet market expectations.

Following this week’s UK data releases, money market prices now show that investors are bracing for 154 basis point hikes by the end of the year.

This is more than is required of the two typically hawkish antipodal central banks and the Federal Reserve which sets the tone.


Above: Market expectations for major central banks, image courtesy of Goldman Sachs.


This implies that three 50 basis point hikes are needed in the three remaining meetings of the Bank of England’s Monetary Policy Committee in September, November and December and a peak in the Bank Rate near 4.0%.

Given that the Bank set a precedent by raising 50 basis points in August, this is an achievable target.

The implications for the pound are significant: if it hits this target, the currency would likely remain supported, but another dovish pivot from the Bank that disappoints relative to expectations could send it lower.

“We think investors have probably gotten a bit ahead of themselves expecting the Bank of England to raise rates to nearly 4.0% and ultimately will have to cut those expectations,” Tompkins said.

A look at the following prices shows that investors have raised their expectations of the Bank through August:


Image courtesy of Goldman Sachs.


As can be seen below, the Bank of England’s expectations have risen more than those of the US:


image courtesy of Goldman Sachs.


And more than in the euro zone:


image courtesy of Goldman Sachs.


The need to raise rates further than the Bank had expected as recently as the Aug. 4 policy update comes on the back of strong labor market data this week that showed wages rose more than expected by the markets.

But it was inflation data that showed annual inflation hit 10.1% growth that fueled expectations.

The Bank itself expects inflation to peak at around 13% later in the year after the next round of energy price hikes and has pledged to fight inflation “no ifs, no buts”. in the words of Governor Bailey.

Adam Cole, senior currency strategist at RBC Capital Markets, also sees rising rate hike expectations, but he uses a different measure and charts against the value of the pound:


image courtesy of RBC Capital Markets.


He notes that this recovery in expectations has not benefited the pound against the euro and the dollar in any meaningful way.

This suggests that sterling exchange rates have decoupled from rate expectations.

Of course, the pound could catch up and climb higher over the next few days and close the gap.

But expectations of a sharp slowdown in UK economic growth are likely to keep buyers at bay for now and the gap between interest rate expectations and sterling exchange rates could remain wide.

It should also be noted in the charts above that the downward slope of the Bank of England chart (2nd chart) is greater than all the others, therefore the Bank is likely to cut more in 2023 than its peers.

This is perhaps what matters most for forward-looking markets, and as a result, the Pound derives little benefit from the sharp rise in near-term money markets.

“Investors continue to anticipate a rapid policy reversal from rate hikes to rate cuts,” Tompkins said.

Capital Economics expects the pound-dollar exchange rate to decline slightly to 1.18, with downside risks.

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