Both internal and external developments suggest the Bank of England could begin to tighten monetary policy shortly ahead or in tandem with the Federal Reserve, which should in turn support both the US dollar and sterling towards the second half of the coming year.
The most significant spike in sterling's price came in June 2014, minutes after Governor Mark Carney's famous Mansion House speech before peaking at $1.7191 in July, its strongest since October 2008.
Since July, when the macro data began to soften and the euro zone crisis persisted, the top BoE officials began to talk down sterling by again strengthening their dovish position. Some support then came in August, when two MPC members, Martin Weale and Ian McCafferty, split from the majority of seven members and began voting for a 25 basis point rate hike through December. The result from the Scottish referendum in September also added some strength to sterling only for it to slide back to hit the 2014 H2 bottom at $1.5486 on December 23. On a year-to-date basis, the pound has retreated 5.9% against the greenback.
In 2015, two major events are expected to shape sterling's curve. First, it is the political uncertainty ahead of May's general elections which is expected to weigh on the pound. The second is the perception of divergence between the Bank of England (BoE) and the Federal Reserve (Fed) in the timing for the first rate hike.
Political uncertainty to weigh on sterling
Sterling is likely to struggle toward the May general elections. Bickering politicians in Westminster and the prospects of thorny post-election negotiations will most likely increase nervousness among investors, with the UK currency suffering some downward pressure.
Westminster saw the first post-World War II hung parliament after the latest parliamentary elections back in May 2010. The historical charts show the pound was falling sharply against the US dollar before the 2010 polls as political uncertainty was rising. Sterling then bounced back and rose some 5.3% between May and December 2010 after the dust settled and Conservatives and Liberal Democrats formed the government.
In its open letter to Westminster published on December 29, the British Chambers Commerce (BCC) called on the politicians to "put the UK's long-term success over tawdry political tactics and point-scoring … that is creating greater uncertainty among businesses and putting the UK’s future prosperity at risk."
With the populist political parties on the rise in the UK, the level of downward pressure on sterling next year will also depend on the speed and legitimacy of the next government in Westminster.
BoE or Fed?
Next year should also see an end to the prolonged streak of ultra-accommodative monetary policy both in the US and the UK.
The combination of stronger-than-expected GDP in the US and weaker, downwardly revised, growth figures in the UK sent sterling down markedly on December 23, with some market participants increasing their bets that stronger US data may lead the Fed to tighten monetary policy sooner than the BoE.
The FOMC minutes from December reiterated that the benchmark federal funds rate would be maintained for a "considerable time," while stating that officials will be "patient" in normalizing interest rates.
Despite weaker-than-estimated GDP figures, growth in the UK is set to continue on a strong footing throughout the next year. Also, the BoE tends to be a bit more upbeat on the overall UK economy than the official statistics may suggest and therefore the reaction from policymakers to the above-mentioned downward revisions remains a question.
Banks strong enough to offset shocks
Regarding the resilience to financial market volatility, the UK banking sector and regulators have gone through the wider reforms and are now significantly better equipped to cope with shocks stemming from normalizing monetary policy. The BoE's latest stress tests - designed under shocking scenario of interest rates rising up to 4% in two years and sterling plunging 30% - showed seven out of eight major UK lenders are strong enough to offset major market shocks.
On the price stability front, inflation remains significantly weak for now but the primary downward pressure on the CPI inflation is only temporary, such as cheap oil, while the impact of a policy decision made today will translate into its full effect only after two years, until when those one-off factors may well dissipate. This should partly offer the BoE enough confidence to begin with at least one 25 basis point rate hike sometime in the second half of the next year in order to stick to its promise of 'gradualism' in a process of policy normalization.
Fragile emerging markets
According to the Bank for International Settlements (BIS) data, nearly three quarters of debt securities issued by emerging market economies are denominated in US dollars, which FX analysts from Rabobank argued should keep the Fed more cautious in easing its policy.
In their latest FX Outlook report, Rabobank strategists said "growth is slowing in countries such as China, Brazil, and Indonesia and there is recession risk in Russia" and due to this "vulnerable nature of world growth the FOMC may indeed determine that patience is necessary in determining the timing and pace of monetary policy tightening."
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