GBP/EUR Rate "At Risk" of Further Weakness as Markets Question the Bank of England's Credibility Once More

Above: File image of Governor of the Bank of England Andrew Bailey. Image: IMF Photo/Cory Hancock. Licensing: CC 2.0.

Pound Sterling is "at risk" as the Bank of England has potentially lost credibility in its fight against inflation, according to analysts who have taken stock of its decision to halt raising interest rates.

The British Pound's selloff is entering its tenth week against the Dollar and could be set to record a fourth consecutive weekly decline against the Euro, thanks to a surprise decision by the Bank to halt its interest rate hiking cycle, despite the UK still printing some of the highest inflation rates in the developed world.

"The UK is one of the few countries for which we really see a wage price spiral in the making. The Bank of England decision to skip is not very reassuring. The pound is at risk," says Ludovic Subran, Chief Economist at Allianz.

Subran says the UK could be about to see "knee-jerk reactions" by the Bank to incoming data that could potentially result in a "stop-and-go hiking cycle".

The Bank justified the decision to leave rates unchanged by saying inflation was now on a set route to the 2.0% target, despite wage growth hitting record highs in July.

The Bank had previously insisted it remains alert to inflation proving persistent owing to elevated wages, but curiously, the Bank dismissed the most recent set of Average Weekly Earnings (AWE) statistics from the ONS which showed wages rising 8.1%.

"The recent path of the AWE is, however, difficult to reconcile with other indicators of pay growth. Most of these have tended to be more stable at rates of growth that are elevated but not quite as high as the AWE series," said a statement from the Bank of England explaining its interest rate decision.

"The decision to pause with inflation still at high levels is going to cause consternation in some corners," says Oliver Blackbourn, Multi-Asset Portfolio Manager at Janus Henderson.

Recent developments prompted analysts at Goldman Sachs to this week slash forecasts for Sterling and say they expect the Pound to Euro exchange rate to return to levels last seen during the market fallout that followed previous Prime Minister Liz Truss's mini budget.

Goldman's analysts note the Bank maintains "a relatively dovish reaction function... a combination of weaker growth, high inflation, and lower real rates is a negative mix for the currency. If the incoming activity data reflect a more negative domestic growth picture than we expect, the currency would come under even more pressure."

Nick Bennenbroek, an economist at Wells Fargo, says the decision to halt the rate hiking cycle "represents a loss of interest rate support for the pound."

"In that context, we view the risks as tilted towards further U.K. currency weakness through early 2024," says Bennenbroek in a note.

The Bank of England voted by a tight margin to leave interest rates unchanged, with Governor Andrew Bailey tipping the scales in favour of a hold.

"The Federal Reserve skipped for the first time with inflation close to 4%, whereas the Bank have chosen to pause with inflation still above 6%. Governor Bailey’s term has seen various communication mishaps, and this pause has the potential to be seen as a further error should inflation prove to be stickier than expected," warns Janus Henderson's Blackburn.

The Bank is nevertheless confident the UK economy is set to slow enough to loosen the labour market and prompt a rise in unemployment and lower wages, which will in turn lower inflation.

To be sure, this has eased pressure on UK bond yields which has brought down mortgage rates and the cost of borrowing more generally, which is supportive of the UK economic outlook.

Ultimately, that should be supportive of the Pound, but in a foreign currency marketplace obsessed with relative yield differentials and worries the Bank of England is making another mistake, more nearterm weakness is likely.

"Judging by the gilt market, the Bank continues to suffer from lower credibility than the Fed or ECB as inflation breakeven rates remain significantly above those consistent with target. Suggestive of a similar lack of confidence in the UK more broadly, in the wake of the decision, sterling weakened further against the US dollar despite gilt yields being higher on the day," says Blackburn.