Will the British pound go from strength to strength?

Following a strong week for the UK currency, traders are now eyeing up the release of inflation numbers on Wednesday

British coins. The pound has had a strong run on the currency markets this year. PA
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Rising inflation and correspondingly higher interest rates have been providing a boost to the British pound.

The currency rose 1.9 per cent against the US dollar last week, and is up by about 8.1 per cent against the greenback so far this year.

Traders have been pushing the British currency higher for months as the Bank of England raised interest rates for successive months in its battle against inflation.

As inflation started to peak in the US and the eurozone, in the UK it remained stubbornly high.

As such, more interest rate increases have been needed to bring this sticky inflation under control.

Interest rates are now predicted to reach 6 per cent by the end of the year and the markets are already pricing in another 0.5 per cent rise in early August.

“Sterling’s more recent strength is predicated on further interest rate rises, where the Bank of England finds itself in the unenviable position of needing to continue the fight against inflation without tipping an already stuttering economy into recession, " Richard Hunter, head of markets at Interactive Investor, told The National.

“By contrast, the US economy is currently showing signs of heading towards a soft landing, which has resulted in some dollar weakness to the benefit, inter alia, of the pound.”

Bulls and bears

But the big question being asked is: Will the pound continue to go from strength to strength?

The bulls that have been pushing the pound higher on the back of the fastest monetary tightening moves by the Bank of England in a generation may find their charge stumbling on Wednesday as the latest UK inflation numbers are released.

Rising interest rates are all very well when it comes to the strength of sterling, but at some point the market will become convinced that something is tipping over in the economy and that will open the door for the bears to start taking the pound down.

That point may come on Wednesday.

“Elevated levels of inflation, coupled with weaker growth, [are] not necessarily a positive for the currency, even if interest rates are going up,” said David Adams, head of G10 FX strategy at Morgan Stanley.

Currently, the pound is about $1.31 to the US dollar, but many traders predict the British currency will start to decline soon.

Monex USA expects the pound to slip back to $1.29 by the end of the year. JP Morgan Chase is predicting an even harsher slide – down 9 per cent to $1.19 by year-end.

Meanwhile, on the flip side of the coin, Nomura forecast a stronger euro, which will climb by about 3 per cent against the pound to £0.88 by the end of September.

Morgan Stanley is forecasting a 6 per cent rise in the euro by the middle of next year.

“We’re starting to see the hedge fund community thinking about the weaker pound because now it’s very stretched,” said Carlos Fernandez-Aller, head of global FX at Bank of America.

“But we all got the weak pound trade wrong earlier in the year, so we’ll see.”

The interest rate balance

The pound bulls, however, point out that even if Wednesday's inflation number is lower, the Bank of England will still be inclined to raise interest rates and keep it than higher for longer than previously predicted.

As such, the central bank will have tighter monetary policy than the US Federal Reserve and the European Central Bank for some time to come.

“The UK has the highest nominal rates in the G-10 but also the lowest real rates in the G-10,” said Michael Cahill, FX strategist at Goldman Sachs, who sees the pound up about 1.4 per cent at $1.33 by the middle of next year.

“We’ve got still very strong inflation and wages. It calls pretty clearly for tight policy and that should benefit the currency.”

If Wednesday's inflation figures show a larger-than-expected fall, it may lower the demand for higher wages and give the Bank of England pause for thought that at least some of their 13 increases in interest rates are now feeding through into the economy.

Still, even if Wednesday's figures show the stickiness coming out of inflation in the UK, the Bank of England is not thought to be anywhere near the end of its rate-tightening cycle.

However, many analysts contend that the Federal Reserve is close and that US economy is more than likely heading for a soft landing.

As such, it is not only the pound that has been doing well against the dollar.

Last week, the euro touched $1.1248, its highest level against the greenback since February 2022. The Japanese yen has also been hitting multi-month highs against the dollar recently.

Nonetheless, while traders have been riding the pound higher on a wave of increasing interest rates, when those rate increases become detrimental to economic growth, the wave comes crashing down.

On Monday, a quarterly survey by Deloitte showed that optimism among British chief financial officers has plunged.

“The burst of business optimism seen in the spring has faded under the weight of inflation and rising interest rates,” Deloitte's chief economist Ian Stewart said.

“Corporates have responded with an increasing focus on cost reduction and cash control.”

The survey said tight monetary policy was viewed by the chief financial officers as the most serious threat to their business, trumping the concerns around geopolitics and energy prices that have dominated for the past two years.

Updated: July 25, 2023, 10:08 AM