Forex Trends, Economic Uncertainty, and the Future of the British Pound
In September, a significant shift in the 2-year rate differential between the United Kingdom and the United States had far-reaching implications for the performance of the British Pound (GBP) within the G10 currency realm.
This transformation can be ascribed, in part, to the divergent monetary policies adopted by their respective central banks. The Federal Reserve (Fed) has steadfastly maintained a hawkish stance, while the Bank of England (BoE) seems to have drawn the curtains on its tightening cycle. The outcome of this discrepancy between the two central banks has triggered profound consequences in the foreign exchange (FX) market.
Looking forward, a cloud of uncertainty hangs over the GBP, as it grapples with potential downside risks in the medium term. Two key concerns loom on the horizon: the prospect of a recession in the first half of 2024 and the mounting political risks associated with the upcoming general election. These factors, compounded by the UK’s reliance on foreign financing, may introduce a higher risk premium into the valuation of GBP, potentially justifying further depreciation of the currency.
Projections suggest that the Euro to British Pound (EURGBP) exchange rate is poised to ascend to 0.87 by the second quarter of 2024, remaining relatively stable at that level through the year’s end. It is imperative to note that these forecasts present a conservative estimate, as they do not discount the possibility of a more substantial upward movement, particularly if a recession materializes during the first half of the year.
Furthermore, the British Pound to US Dollar (GBPUSD) exchange rate is anticipated to rise to 1.32 by the conclusion of 2024. However, it’s crucial to emphasize that this projection reflects a broader bearish outlook on the US Dollar over the medium-to-long term, rather than signalling an intrinsic strength in the GBP. The relative performance of the GBP continues to be subject to the overarching dynamics of the global currency markets.
The Bank of England (BoE) opted to maintain its status quo in September by keeping interest rates unchanged. This decision was characterized by a tight 5-4 vote within the policy committee, underscoring the divisions and hesitancy within the committee.
While the BoE did not completely rule out the possibility of future rate hikes, the prevailing belief is that forthcoming economic data may not strongly support further tightening of monetary policy. Several factors contribute to this perspective. Chief among them are indicators pointing to inflation levels softer than initially anticipated, which add to the uncertainty surrounding future rate hikes. Moreover, reports of weak retail sales and lacklustre readings in the services Purchasing Managers’ Index (PMIs) allude to an economic climate that may not favour additional tightening measures by the BoE.
Considering these considerations, the decision has been made to recalibrate projections for terminal interest rates to align them with the current policy rate of 5.25%. This adjustment mirrors an assessment of the economic landscape and the likelihood that the BoE may not pursue further rate hikes in the near term.
However, it is imperative to acknowledge that the BoE’s reaction function has exhibited a degree of volatility. This implies that there remains a small but tangible risk that the central bank might consider an additional 25 basis points (25bp) rate hike in the future, depending on evolving economic conditions and data. This potential move is not entirely off the table, highlighting the fluidity and uncertainty inherent in the current economic and monetary policy environment.
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