Pound Sterling Looks to Bank of England to Arrest Declines against Euro and Dollar

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Will the Pound rise or fall in the wake of today's Bank of England policy update?

If the Bank raises rates by 75 basis points - its largest hike since 1989 - and turns more optimistic on the economic outlook the currency could rise.

But this is a big ask for a central bank that has tended to undershoot market expectations and place heavy emphasis on the downside risks facing the economy.

The most compelling down-case outcome would see the Bank hiking by less than expected (going with 50bp) and warning the economic outlook remains challenging with risks to the downside.

Currency market analysts meanwhile say the odds favour a downside reaction, with any post-decision gains likely to be sold into and proving short-lived.

Dour Sentiment Ripe to be Challenged

Ahead of the decision the Pound to Dollar exchange rate tests fresh post-1985 lows at 1.1324 while the Pound to Euro exchange rate remains in touching distance with this week's multi-month lows at 1.1462.

Something Sterling does have on its side is the overwhelmingly negative investor sentiment pitted against it, which means short-term risk-reward is skewed to the upside.

It's been a poor year for the Pound thanks to a global energy crisis, domestic balance of payments deterioration, falling stock markets, a relentlessly strong Dollar and an indecisive Bank of England.

Although many of these problems are medium- to long-term issues and global in nature, Bank of England monetary policy is the one area where policy makers have the ability to offer the Pound some near-term relief.

Should the Bank surprise markets with a more 'hawkish' tone some of the pessimism and negative positioning could be challenged, allowing for a short-term leg higher.

It's a 75bp Hike, Followed by 2x50bps

"We expect the MPC to hike rates by 75bps to 2.50% and vote in favour of Gilt sales at a pace of £10bn/qtr. With the fiscal and energy situations so fluid, we expect little guidance beyond this meeting," says James Rossiter, Head of Global Macro Strategy at TD Securities.

This puts TD Securities in line with the market consensus for a 75bp move.

At the most basic level, meeting consensus would be a neutral outcome for a currency and would therefore allow Sterling to defend recent levels against the Euro and Dollar, all else being equal.

In fact, TD Securities holds one of the more bullish calls regarding the Bank's future policy decisions.

They see one 75bp hike followed by two successive 50bp moves in November and December, meaning the Bank would marginally undershoot the market's expectation for 200bp of hikes over the remainder of the year.

Above: Robust nominal wage growth should encourage the Bank of England to hike by 50/75bp - TD Securities.

If this is met it could support the Pound into year-end. Nevertheless, TD Securities are bearish.

"We don't think the BoE can do much to rescue the faltering GBP," says Mark McCormick, Global Head of FX Strategy at TD Securities.

TD Securities says Sterling will ultimately continue to reflect global developments and analysts therefore look for further declines in Sterling against the Dollar.

"The USD (and risk sentiment) has also lagged behind the move in 2y real rates, increasing the prospects that the broad USD rallies in the weeks ahead. In turn, we like GBP lower and pencil a move to 1.11 towards yearend," says McCormick.

Improved Economic Outlook

A 75bp rate hike combined with any improved commentary from the Bank could boost the Pound on the day.

TD Securities sees a 50% chance of such an outcome, which would deliver about 0.20% upside in GBP/USD.

The Bank's August economic forecasts were dire as they showed a long running recession would commence at year-end while inflation would peak at an eye-watering 13% in October.

This contributed to a selloff in the currency though August and into September.

"As soon as the BoE’s forecasts hit the wire, surprising markets by the Bank’s grim outlook for higher inflation and lower growth in the UK, GBP would start to sell off," says Themistoklis Fiotakis, Head of FX Research at Barclays.

Above: The UK government is offering material fiscal support to the economy, image courtesy of Barclays.

But the economic outlook has since changed as the new government of Liz Truss has announced substantial fiscal support in the form of an energy price cap for businesses and households.

The Bank will need to respond to this improved outlook on Thursday, and if the market is responsive to improved projections the Pound could receive a boost.

A more 'hawkish' outcome, according to TD Securities, would see the Bank hike 75bp and offer "slightly firmer forward guidance, noting that policy will need to be tightened further at coming meetings, perhaps on the back of the Truss government's evolving fiscal stance."

They see a 10% chance of such an outcome, under which Sterling would rise by half a percent.

Dominated by Doves

There is nevertheless a strong likelihood the Bank defers to its 'dovish' comfort zone and opts for a 50bp rate hike on the basis UK economic growth would suffer under an aggressive rate hiking regime, disappointing against expectations for 75bp.

"We expect the Bank of England to raise its policy rate 50 basis points to 2.25%... and follow up thereafter with a 50 basis point rate increase in November and a 25 basis point increase in December," says Nick Bennenbroek, International Economist at Wells Fargo Securities.

Such an outcome would be outright bearish for the Pound which has fallen 3.75% against the Euro in 2022 and 16.00% against the Dollar.

"With Bank of England tightening set to lag the Fed and fall short of market expectations, we expect renewed downside in the pound," says Bennenbroek.

Above: The Monetary Policy Committee holds an inherently 'dovish' bias.

Nevertheless, under such as scenario downside in the Pound would be limited if the Bank were to deliver a more upbeat tone about an improved economic growth outlook now that the government has radically increased their fiscal support.

A worst-case outcome for the currency would come in the form of a 50bp cut and an unchanged opinion on the outlook for the economy.

TD Securities see 40% chance of such an outcome, in which case Sterling would fall a percent.

Sterling's 'Doom Loop'

Longer-term TD Securities says the focus for Pound Sterling will hinge more on the country's terms of trade shock and growth outlook and less on the central bank response.

"The doom loop for the likes of EUR and GBP now focuses on how the local energy shock feeds back into growth expectations and risk sentiment, reinforcing currency weakness. While both the ECB and BoE want to slow and eventually reverse this loop, monetary policy can only limit the slowdown significantly ahead of the coming winter," says McCormick.

As a result, he says the Euro and Pound will "remain in unique situations relative to other major currencies for the remainder of the year".

"We like to selectively position for the downside relative to the USD, especially given the recent positioning squeeze running through the market now. In light of the recent fiscal stimulus package, the rub for GBP is that boosting demand will exasperate inflation," says McCormick.

McCormick is of the view that lowering household utility bills will encourage more spending, creating the conditions for an extended bout of above-target inflation.

This would in turn invite the Bank of England to pursue further rate hikes, which in turn squeezes the economy further.

"The BoE, for its part, could respond with further monetary policy tightening, which will intensify the negative growth loop. At current levels, the BoE will underperform market expectations that call for a much more aggressive tightening cycle," says McCormick.

Longer-term the outlook therefore remains challenging for the Pound and any near-term gains are therefore likely to be viewed as short-lived.

Those readers with currency payment requirements out of Sterling should therefore be nimble and take advantage of any appreciation.