Sterling may come under further pressure against the US dollar, while the expectations of another round of monetary easing in the euro zone may result in an even stronger pound against the currency of Britain's major trading partner.
The Bank of England (BoE) said earlier this year,
"... there was a risk that divergent monetary policy trends, as well as stronger prospects for growth in the United Kingdom than in the euro area, might continue to put upward pressure on the sterling exchange rate".
This status quo is expected to continue further into the next year as the major central banks prepare changes in their monetary stance.
The BoE remains cautious on the outlook for the economy and inflation, suggesting it may hold onto the current monetary level for some time to come. Meanwhile, the US Federal Reserve (Fed) has so far offered enough clues to the market that the overwhelming majority would not be surprised if it lifts rates as early as December this year.
Sterling versus dollar is then seen coming under further downward pressure partly due to the strong dollar-buying reaction to the Fed's rate hike kick-off. However, the level of reaction to the pair may very well depend on how much the market bets on the December hike. So far graphics show nearly 80% of market participants expect a December lift-off.
Forex analyst Kathy Lien of BK Asset Management argued last week: "The big problem for the BoE is the strength of the currency."
"Since the beginning of the year, sterling appreciated between 8 to 10% versus the euro, Australian, Canadian and New Zealand dollars. Not only has the strong currency putting downward pressure on prices in a low inflation environment but it also hurt exports. The UK conducts the majority of its trade activity with the European Union and the recent slide in EUR/GBP means trouble for the economy …"
The European Central Bank (ECB) is seen loosening its monetary policy even further in December by either expanding the volume of quantitative easing (QE), or by cutting the bank rates further, leading to stronger appreciation of sterling against the euro currency.
This is partly due to slower growth and significantly weak inflation in the European common currency bloc. While the situation in the UK remains broadly similar at the moment, the upside risks are bigger in Britain, given its stronger economy and robust labor market, and independent and flexible monetary watchdog.
Given the fact that Europe remains the UK's major trading partner, a nearly 10% appreciation of sterling against the euro since the start of this year indeed indicates a problem, adding to the BoE's cautiousness when considering the timing of the first increase in base rate.
However, the level of the BoE's cautiousness toward the risks stemming from sterling's appreciation against the euro may again depend on how concerned the BoE is with this currency trend. The UK trade data has been persistently showing significant trade deficits so far since late 1990s, so a further deterioration in trade balance would not be of much surprise. Plus the GDP growth in the UK has been very well offset by strong services output and buoyant domestic consumption, given the strong growth in real income in Britain.
Economists still expect the BoE to lift rates, for the first time in more than six years, as early as the middle of next year.
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