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The British Pound could be on course to register notable losses against the Dollar, Euro and a host of other major currencies this November as investors adjust to the Bank of England’s latest dire economic warnings.
The Bank signalled at its November Monetary Policy Report that the UK economic recession it has been expecting for some time will now be even deeper than previously thought.
“It’s proved to be yet another dismal day for the pound as forecasts of a long recession cast a dark shadow over the UK economy,” says Susannah Streeter, senior investment and markets analyst, Hargreaves Lansdown.
Bank Rate rose 75 basis points to a 14-year high at 3.00% – as expected – but the clear message from Governor Andrew Bailey and the Monetary Policy Committee is it won’t need to go much higher than 4.0%, which is significantly lower than investors had expected ahead of Thursday’s decision.
It is this adjustment lower in Bank Rate expectations that helps explain the mechanical downside reaction in the Pound.
A higher Bank Rate raises the interest paid on UK financial assets, which in turn attracts foreign investor capital, in turn bidding the Pound higher.
But if Bank Rate is not sufficiently attractive relative to that in other countries the UK might be unable to attract much-needed capital to fund its twin budget and Balance of Payments deficits.
“We can imagine the terminal rate moving lower towards 4.50%, which again would leave GBP with insufficient rate premium to be attractive given the UK’s fragile balance of payments outlook,” says Shahab Jalinoos, Head of FX Research at Credit Suisse.
The November MPR mirrored August’s MPR: the Bank hiked but signalled a slowdown in the economy and that interest rates would not need to rise as far as markets were expecting.
“The MPC is now more cautious about what comes next,” says Ruth Gregory, Senior UK Economist at Capital Economics. “The MPC poured cold water on the markets’ expectation that rates will rise to a peak of 5.25%.”
The Pound fell in response and kept falling through the month of August, registering a 3.0% decline against the Euro and a 4.5% decline against the Dollar.
If the post-BoE reaction in November mirrors that of August then further losses in the Pound look likely.
“The move has been perceived as a dovish hike by markets and once again GBP is reacting to the gloomy projections from the Bank rather that to the fact that Bank rate is now higher,” says Jane Foley, Senior FX Strategist at Rabobank.
The Pound to Euro exchange rate (GBP/EUR) fell to a low of 1.1450 in the wake of the decision, and the Pound to Dollar exchange rate (GBP/USD) fell to a low of 1.1157.
Following the Bank’s update, Rabobank says it maintains its forecast for GBP/USD at 1.06 on a six-month horizon and EUR/GBP is forecast to climb to 0.90 over this period, giving a GBP/EUR target of 1.11.
GBP/EUR (top) and GBP/USD (bottom) at one-day intervals.
The Bank’s latest forecasts revolve around a key assumption that Bank Rate will rise to meet the market’s expectations, which at the time of the Bank’s calculations for the November MPR were set for a peak of 5.25% in 2023.
Under such a scenario the Bank’s economists forecast inflation to fall back to 0% in three years, taking it well below the target of 2.0%.
Under the scenario economic growth is projected to continue to fall throughout 2023 and into the first half of 2024, “as high energy prices and materially tighter financial conditions weigh on spending,” says the Bank.
The UK economy is now forecast to contract 1.9% in 2023, a downgrade from August’s projection for -1.2% while unemployment is expected to increase to 4.9%, up from the previous estimate of 4.7%.
In fact, the UK economy is seen contracting for eight quarters in succession, the longest UK recession since the current modern measurements were put in place.
Therefore the message the Bank is sending is this: Bank Rate does not need to rise to 5.25%, as the markets expected, and it must come down in due course.
In response, the market’s pricing of the terminal Bank Rate has fallen below 4.75%.
Derek Halpenny, Head of Research for Global Markets EMEA at MUFG says the Bank has delivered, “terribly grim projections… that spell warnings for GBP”.
As a result of the rate hikes the Bank has already delivered, MUFG notes UK bankruptcies are already rising significantly, with much of the rate hiking impact still to come.
“The desire to front-load may mean a 50bp hike in December, but then that could be the end. Getting to our original target of 4.00% looks less plausible now,” says Halpenny.
He adds the UK will stand out from other key G10 economies and is set to under-perform, leaving “further GBP depreciation as the inevitable consequence.”
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“By the time the BoE next meets, it is likely that recessionary conditions in the UK economy will be even more apparent. This suggests that there are no guarantees that GBP will react well to higher rates in view of the huge headwinds facing the outlook for growth,” says Rabobank’s Foley.
The next pivotal moment for the Pound will be November 17’s Autumn Statement where Chancellor Jeremy Hunt will lay out his fiscal plans, which are tipped to include a reduction in spending and higher taxes.
This restrictive fiscal policy mix will add to the constraints imposed by tighter monetary policy from the Bank of England, suggesting a bleak winter and 2023 awaits the Pound.
“The stage is now set for a fresh political debate about fiscal policy, and whether expected spending cuts are simply the wrong medicine for an ailing economy,” says Hargreave Lansdown’s Porter.
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