Battered Pound to Remain Vulnerable say Analysts

• GBP hammered in wake of BoE decision
• As fears of recession grow
• But other central banks to take a similar view
• Will release pressure on GBP

Above: Bank of England Governor Andrew Bailey talks to the press following the May policy decision announcement and MPR. Copyright Pound Sterling Live, still courtesy of Bank of England.

The British Pound approaches the weekend attempting to recover some of the significant losses against the Euro, Dollar and other currencies that came after the Bank of England painted a bleak picture of the economic outlook.

The Bank of England surprised markets with the sheer gloom of the economic forecasts published in its Monetary Policy Report, and some currency analysts say this could ensure the British Pound remains on the back foot for some time to come.

"The outlook for the pound will remain grim just like the GDP forecasts provided by the BoE today," says Derek Halpenny, Head of Research for Global Markets EMEA at MUFG.

The Pound to Euro exchange rate plunged to a low of 1.17 but has since recored to 1.1740, while the Pound to Dollar exchange rate hit a low of 1.2325 before staging a recovery to 1.2365. (Set your FX rate alert here).

But other developed market economies face similar inflationary and growth challenges to the UK, meaning other central banks will have to cool their own rate hike ambitions over coming weeks.

When this happens the Pound could start to reclaim lost ground.

In fact it is worth noting the Pound did OK against a number of other currencies that have benefited from significant rate hike expectations, such as the Australian and New Zealand Dollars (see below chart).

The market is realising too much is expected of central banks and those that had the richest expectations will have the most to give back.

Above: GBP against EUR (blue), USD (orange) and AUD (turquoise) in the hours following the Thursday rate decision.

A Surprise

Bank of America's UK Economist Robert Wood says the Bank of England's reputation for dishing out surprises remains firmly intact after May's Monetary Policy Report.

Wood says the Bank has effectively surprised markets once again, this time with some voters on the Monetary Policy Committee supporting a 25bp hike but preferring not to guide to more hikes.

This is indicative the MPC could be nearing a pause to the hiking cycle.

"But most headline grabbing was the BoE's growth forecasts," says Wood.

They cut the full year GDP growth forecast for 2023 by 150bp to -0.25%.

"GBP has been battered in the aftermath of the BoE rate decision as the market focuses on the key headline that the MPC now expects the economy to contract in 2023," says Wood's colleague at BofA, FX Strategist Kamal Sharma.

Markets Will Need to Lower their Expectations

The Pound's weakness is indicative of a simple misalignment: that between where the Bank of England thinks interest rates are going and where markets think they are going.

The Bank's forecasts show that GDP will fall into recessionary trajectory if the market gets its way and rates are hiked to over 2.5% by 2023.

"The surprise for the market was large in part because the market was pricing 8-9 more rate hikes from the BoE in the next 12-18 months and more than 25bp hikes in the next two meetings as well as May," says Wood.

However, Wood points out, "8-9 rate hikes from here would probably cause a recession, coming as it does in the middle of the biggest annual fall in real income since at least 1955."

If we look at the below chart we can see the Bank's GDP forecast path based on current market expectations (top chart), it clearly shows a recession by the first half of 2023.

Above: GDP outcomes if rate hike expectations follow the market's assumptions vs. if Bank Rate were kept steady at 1.0%

But the second chart shows what would happen in the event that rates are left as they are, and recession is avoided.

"Interest rate expectations softened as markets focused on the weak growth projections. In essence investors doubt that the MPC will need to be quite as aggressive on rates as they previously believed," says economist Philip Shaw at Investec.

More Hikes are Coming, Just Not a Lot

The Bank said more rate hikes are likely, but the important takeaway from the day is that the market is expecting too many hikes.

Sterling will continue to remain under pressure until such a time as expectations come down and settle at more realistic levels.

"We still think the MPC will probably only be able to hike once more in this cycle, by 25bp in August," says Daniel Vernazza, Chief International Economist at UniCredit Bank.

If the Bank kept interest rates unchanged from here recession could be avoided, as per those forecasts in the above table. But, inflation would burn too hot.

The below shows the pay off on inflation if rates follow market expectations vs. stay where they are.

As can be seen, if rates don't move higher inflation moves even higher.

Therefore the Bank will try and find a middle ground.

"The message to market participants is that they are probably expecting too many rate hikes," adds Vernazza.

Bank of America stick to their call for three more 25bp hikes in addition to May's hike and a cut in 2023.

"We continue to expect the BoE to hike rates 25bp in June, August and November, with risks shifting today in our view to the BoE hiking only twice more," says Wood.

Investec's Shaw notes that by the end of Thursday end-2022 Bank rate expectations had eased back by 12bps to 2-2.25%.

This implies at least another four rate hikes, which is still potentially elevated but is nevertheless starting to approach more realistic levels.

"We maintain our forecast for a further 25bp Bank Rate Rise, to 1.25%, in August, followed by a pause as the MPC tries to assess the impact on demand from the energy and cost shock," says Ross Walker, Chief UK Economist at NatWest Markets.

The Pound to Remain Under Pressure Near-term

Walker notes markets reacted dovishly to the Bank of England in what amounts to "an overdue correction".

"We think there is further to go," he says.

This would imply further losses for the Pound in the near-term.

MUFG's Halpenny also says Sterling is likely to remain under pressure:

"The toxic mix of inflation moving higher to 10% and that peak inflation rate much later for the UK than for the US or the euro zone coupled with a Q/Q contraction in GDP in Q4 will continue to act as a big incentive to sell the pound."

BofA's Sharma says waning rate and cyclical support will keep Pound Sterling under pressure at a time of increased signs of slowing capital inflows into the UK.

"We have been bearish GBP since the start of the year, projecting GBP/USD to be at 1.24 by year-end. Risks are clearly biased to the downside to those forecasts. Near-term sentiment has clearly deteriorated and will keep GBP under pressure. Our preferred expression is higher EUR/GBP," says Sharma.

Above: GBP/EUR and GBP/USD at daily intervals.

The big losses in Sterling are almost certainly bound to see some follow through momentum over the near-term, until such a time as the market reaches peak negativity towards the UK economy.

It is also possible positioning amongst investors for further GBP downside will become stretched, at which point losses can start to fade.

The market will meanwhile inevitably lower the number of rate hikes they expect on the back of the May Bank of England event, taking the Pound lower to a more stable equilibrium.

At some point the rich expectations for future BoE rate hikes will be washed out to more sustainable levels that are more in line with BoE expectations.

But the Bank of England does appear to be ahead of the curve here: the UK is in no worse a position than many other developed countries in terms of inflation and slowing growth prospects.

Therefore it is highly likely that other major central banks start communicating a similar message as the reality of the upcoming growth slowdown emerges.

It would be at this point that the Pound can start making a material recovery.

This is however at least a couple of months away.

"Remember the BoE were amongst the first to hike... and they're leading the G10 central bank tightening cycle. Today's BoE narrative = tomorrow's Fed narrative (and the ECB is well behind the curve). This could be an important inflection point for DM bond markets," says Viraj Patel, FX & Global Macro Strategist at Vanda Research.