After rallying in September, what next for the pound?

BY DEB SHAW | 

  • In the short-term, pound looking overbought - markets pricing in a lot of optimism regarding the future
  • Reality is limited change in economy, one-and-done rate hike, limited progress on Brexit negotiations
  • Pound will ultimately strengthen, but remains subdued thanks to ongoing Brexit-related uncertainties

Mark Carney, the current Governor of the Bank of England, is a traditional central banker who avoids surprises. Unlike his Canadian counterparts, Carney likes to telegraph his intentions well in advance of acting. His latest message to markets is that interest rate hikes are on the table, despite the uncertainties caused by Brexit. In anticipation of a hike in the “next few months”, the pound has been strengthening relative to most other currencies. In fact, the pound is now so strong that the currency looks overbought in the short-term time frame – something we have pointed out for currency pairs such as EUR/GBP and GBP/USD.

 

A rate hike, then what?

As pound sterling rallies on the expectation of higher future interest rates, the natural question many are asking is: then what? Looking at economic data in the UK, not much has changed.

Inflation remains well above the BoE’s target, thanks to import-fueled price increases following the pound’s sell-off in 2016. Given that Brexit was a one-off event, inflation is not a great reason to raise interest rates. Similarly, growth remains positive, but far from energetic. Thus neither growth nor inflation are sufficient reasons to raise rates today. A summary of recent UK economic growth and inflation is shown below:

One-off inflation and subdued growth

UK growth inflation
Source: UK Office for National Statistics

 

Not normalization, more “one-and-done”

The BoE initially hinted at a rate hike at its last meeting on September 14, when the MPC stated that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months”, despite voting 7-2 to maintain the current status quo.

Later, on September 18, Carney spoke at an IMF event explaining the Bank of England’s thinking. Specifically, he said that monetary policy may have to “move in order to stand still” given that global equilibrium interest rates are rising. This suggests that the BoE is hiking because others, such as the US Fed and the Bank of Canada, are hiking. As opposed to a desire to move away from today’s emergency interest rates, Carney’s quote suggests that the BoE is only seeking to keep rates in line with global peers.

This is a weak rationale for hiking rates, and suggests that the strong reaction in the pound to the BoE’s statements on September 18 may be overdone.

 

Limited clarity on the Brexit negotiations front

Looking at the Brexit negotiations, tangible progress remains limited, although recent comments have been more constructive. According to a recent article in the Financial Times, the EU’s Barnier recently stated that it may take weeks, or even months, to achieve sufficient progress. Barnier remains disappointed with the UK’s reluctance to accept the jurisdiction of the European Court of Justice, although he has stated that there has been a “new dynamic” in the talks. His UK counterpart, Brexit Minister Davis, is more upbeat. Davis claimed that significant progress has been made in areas including social security, Northern Ireland and exit payments. The conciliatory remarks from both sides have helped the pound strengthen on increasing expectations of a Brexit deal. While expectations are now more positive, measureable progress remains limited.  

 

All in all

With the market’s interest rate expectations racing ahead of reality, and limited tangible progress related to Brexit, optimism towards the pound has been impressive. After mostly languishing in oversold territory following Brexit in early 2017, the pound is now looking overbought against quite a few other currencies. While the pound will ultimately strengthen once Brexit-related uncertainties dissipate with time, today the currency is due for a short-term correction.

Topics: British pound

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