The British pound has risen to a 3-month high against the U.S. dollar on expectations that the Federal Reserve could slow the pace of interest rate hikes and a new U.K. Government budget proposal. The recent move higher in GBP/USD has now erased all losses recorded during Liz Truss’s tenure.
Earlier this week, minutes from the most recent FOMC meeting indicated that the U.S. central bank could ease the pace of interest rate hikes at the next meeting on Dec. 15, after delivering four consecutive 75 basis points (bps) rate increases. The Fed has imposed a total of six interest rate hikes so far in 2022, lifting the interest rates by a total of 375 bps - the bank’s fastest tightening in around 40 years.
A Mix of Weak Dollar and Improving UK Fundamentals
The tight monetary policy, aimed at fighting 4-decade high inflation, has driven the U.S. dollar to the highest level in 20 years, with the greenback rising more than 8% against the euro since the start of 2022. U.S. inflation slightly eased to 7.7% in October, though still a far cry from the Fed’s target of 2%.
A possibility of a 50 bps interest rate hike next month has weighed on the U.S. dollar, and the greenback’s weakness is one of the main factors behind the pound’s 20% jump since hitting an all-time low during the mini-budget debacle in September.
A recovering sterling bodes well for businesses and consumers, and could in turn help push down the rampant inflation driven by food and energy costs. However, despite the recent jump, the pound remains down against its U.S. counterpart this year.
Analysts believe that the new U.K. prime minister Rishi Sunak has restored the embattled investor confidence in the country’s financial credibility, mitigating the risk of purchasing sterling-denominated assets.
“Investors feel Rishi Sunak appears more resolute than his predecessor in trying to address rising borrowing costs,” said Fawad Razaqzada, an analyst at City Index, one of the most popular forex brokers in the UK and a columnist at Investing.com.
BoE’s Warning About Inflation
Meanwhile, the Bank of England’s (BoE) deputy governor Sir Dave Ramsden warned the central bank could keep raising interest rates if inflationary pressures persist. Ramsden's remarks challenged chancellor Jeremy Hunt’s views that the recently announced £55 billion budget proposal would allow for “significantly lower” interest rates.
The budget plan, which came as a part of the UK government’s Autumn Statement, outlined significant tax hikes and spending cuts. Ramsden argued that:
“[The measures] do not come into effect until April 2025 so will have very little effect over the Monetary Policy Committee’s (MPC) three-year forecast horizon, relative to what was assumed in the November monetary policy report.”
The BoE said in the past it would revisit its interest rate plans if the Autumn Statement measures made an immediate impact on inflation and the country’s economy. However, Ramsden is still of the view that the BoE must continue tightening the monetary policy. He said:
“I expect that further increases in the bank rate are going to be required to ensure a sustainable return of inflation to target.”
Ramsden stated clearly that the BoE is considering another jumbo interest rate increase at the next meeting in December if he saw that companies were able to raise prices further and increase wages notably higher than the 2% inflation target. He added he will continue to “respond forcefully” if the outlook indicates that inflation will persist in the future.
The BoE hiked interest rates by 50 bps in August and September, and by another 75 bps in October, taking the official rate to a 14-year high of 3%.
Rokos Capital Management, a hedge fund led by billionaire Chris Rokos, said the British pound still appears “vulnerable” to new declines, adding that the looming inflation could have significant implications on British society.
The hedge fund told investors that Britain had suffered a heavier blow compared to other developed countries due to several factors including Brexit, de-globalization, and the coronavirus pandemic. Such a gloomy outlook is making it increasingly challenging for UK lawmakers to tame the raging inflation, Rokos Capital Management wrote in a letter to investors.
“The recession that is required to tame inflation in the UK is deeper than that needed elsewhere, with potentially serious societal implications. Sterling looks vulnerable.”
Rokos added that it could become more optimistic about Britain’s prospects in case of a “softer Brexit” or higher immigration.
Summary
The fall in U.S. bond yields has fueled a rally in stocks and bonds, while also sending the U.S. dollar lower from its multi-year highs. The drop in the greenback has coincided with improving risk sentiment in the U.K., ultimately sending GBP/USD to over 1.20 again, which is a 3-month high for the major currency pair.