© Reuters. FILE PHOTO: British pound and US dollar banknotes are seen in this illustration taken on March 10, 2023. REUTERS/Dado Ruvik/Illustration
By Naomi Rovnik
LONDON (Reuters) – It is the best-performing currency this year in the Group of Ten advanced economies against the dollar. But Sterling’s line of strengthening is about to be tested as a series of interest rate hikes has heightened concerns about growth.
The British pound, at around $1,251, rose on Thursday from a one-year high against the dollar, after being partly driven by expectations that US interest rates will fall later this year while UK borrowing costs will rise.
On Thursday, the Bank of England raised interest rates for the 12th consecutive time, to 4.5%. But in a sign that optimism was beginning to fade from Sterling’s long trade, the pound fell 0.9% in the hours after the BoE’s decision.
Investors are now focusing less on anticipating interest rate differentials in the US and UK and heading towards a view that the pound will weaken as interest rate increases impact the economy, although on Thursday the Bank of England dropped its forecast of a recession.
While the dollar “could get another leg,” as the US at least stops tightening policy, in the case of sterling, “you don’t want to chase this much more,” he said. Barclays (LON): Global Head of FX Strategy Themos Fiotakis.
The pound has gained about 3.5 percent against the dollar so far this year and is up about 17 percent from its lows in the wake of the disastrous September mini-budget.
Deutsche Bank (ETR:) said on Wednesday that it no longer believes the British currency is attractive in the short term.
According to money market pricing, the Federal Reserve has reached the end of its most aggressive rate-raising cycle in decades and will soon start cutting rates as recession risks grow in the United States. These expectations are already built into how the dollar trades against rival currencies.
After Thursday’s Bank of England interest rate decision, markets priced in UK interest rates to peak at around 4.8% by November.
Interest rate differentials are a major driver in currency markets, but some analysts said the gap between US and UK borrowing costs was just one part of the story.
Sterling was also boosted by greater-than-expected resilience in the domestic economy and hopes that China’s recovery after easing strict coronavirus restrictions will be positive for European growth.
This Chinese boom has yet to materialize, Barclays’ Viotakis said, making it difficult for the GBP bulls to hang on to their trades. Speculators are holding a net long position in sterling at $80m, after they were short to $6.3bn a year ago.
Last week’s data showed factory activity in China contracted unexpectedly in April.
The target for Viotakis is $1.28/GBP, which indicates that further gains will be limited to an upside of around 2% from current levels.
recession risks
After a 440 basis point rally in the session, analysts said BoE tightening is coming to an end and is increasingly likely to manifest in a weaker economy in the future.
We don’t expect any further increases,” said Laureline Renaud Chatelain, fixed income analyst at Pictet. “We expect the UK to fall into recession in the second half of the year.”
The International Monetary Fund expects the UK economy to contract by 0.3% in 2023, lower than previous forecasts for a contraction of 0.6%.
Craig Inches, head of interest and monetary rates at Royal London Asset Management, said the UK inflation outlook, at 10.1%, was complicated by still-high wage increases amid a Brexit-related worker shortage.
He added that interest rate setters may have been hoping to “sit on their hands as long as possible because they know that large fundamental effects will cause inflation to drop”.
Eugene Villaltheis, head of multi-asset investment management for Europe at Fidelity International, who also forecast a recession in the UK, said he was negative about the pound against the euro and the yen.
The European Central Bank raised interest rates a week ago and announced further increases after starting to tighten later than its major peers. The British pound held steady against the euro on Thursday, approaching a five-month high.
The Bank of Japan is widely expected to end its controversial policy of buying massive amounts of government bonds to suppress domestic borrowing costs, in a move likely to boost the yen.
Noting that sterling has had the best volatility-adjusted returns in the G10 this year, Shreyas Gopal, strategist at Deutsche Bank, said, “We no longer believe that sterling offers an attractive return on risk in the short term.”