British Pound 'Underpinned' Near-Term

Above: Viraj Patel of ING does see some follow-through upside momentum in the Pound, even if the longer-term prospect facing the currency is broadly negative.

Further gains for the British Pound are possible as the rally triggered by the comments made by Bank of England Governor Mark Carney still has momentum.

However, analysts we follow are eager to stress the gains are likely to be short-term in nature and that it remains too early to call the start of a long-term recovery in the Pound that would take the currency to levels witnessed before the EU referendum back in June 2016.

But a base in the Pound is certainly becoming more established as central bankers take control of foreign exchange market action with a unified shift towards warning of the need to start raising interest rates over coming months.

“Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional,” says Carney in a speech to delegates at a central banking forum organised by the European Central Bank.

The comments sent the Pound to Euro exchange rate to a weekly best at 1.14 and the Pound to Dollar exchange rate to a weekly best at 1.2976.

For markets, the speech represents a significant shift in policy bias, especially given that it was just over a week ago that Governor Carney told us that “now is not yet the time [to begin raising interest rates]”.

“One has to question the underlying rationale for this 'U-turn' and whether Bank officials have all of sudden seen some inflationary pressures in the UK economy that we have not,” says Viraj Patel, an analyst with ING Bank N.V in London.

Patel has previously argued that the Bank is faced with a “cacophony problem” whereby some on the Monetary Policy Committee are arguing for an interest rate rise and others are arguing for no change.

This mixed messaging could suggest a dilemma, even if in reality it is a sign of healthy debate at an independent organisation.

But, there is a bigger question to ask and that is whether central bankers talking to each other? It would appear so.

Analyst George Saravelos at Deutsche Bank says there is “an apparent co-ordinated shift from developed world central banks in a more hawkish direction, all apparent in rhetoric from the ECB, Fed, Bank of Canada, Bank of England and likely others in coming weeks”.

As such, “last week’s BoE policy confusion – and what we described as a “cacophony problem” – has now been resolved and it looks increasingly likely that the BoE will hike interest rates sooner than many had previously expected,” says Patel.

Markets reacted with conviction, sending Pound Sterling up close to 1% against the USD and EUR, and this should support the currency over coming days we are told.

“Prospects of a ‘withdrawal of stimulus’ – and the move higher in short-term UK rates – will underpin GBP in the near term,” says Patel.

However, the comments do not yet reflect any kind of game-changing moment for Sterling on a longer-term basis.

“Our initial message would not be to overstate the implications of the Governor’s hawkish shift today; a reversal of the post-Brexit 25bp rate cut does not necessarily equate to a full-blown hiking cycle – especially given the tepid domestic inflationary pressures,” says Patel.

For investors to start factoring in a Fed-like policy normalisation cycle in the UK - something that would presumably undepin a more sustained rise in the Pound - “one would probably need to see a (permanent) uptick in wage inflation and a reduction in the long-run Brexit-related economic risks,” says Patel.

It is worth noting that much of Carney’s address to delegates at the ECB forum centred on expectations for a pickup in business investment in the UK which would help boost wages.

"Right now in the UK, output is approaching potential and the capital overhang looks set to be eliminated over the next few years,” says Carney. "If companies want to expand they're going need to invest."

However, Patel says we should not expect a pickup in activity in the near-term, “which again leaves us scratching our heads when it comes to the recent hawkish rhetoric”.

What Does this Mean for the Pound's Outlook?

Financial markets are now pricing in around 35bp-worth of Bank of England tightening by end-2018.

“Any further BoE-driven GBP upside would seem unlikely,” says Patel.

ING’s short-term GBP/USD financial model suggests that the pound is also no longer trading with any political risk premium – the 1.2950-1.3000 area looks “fair” after the recent hawkish BoE re-pricing.

“All of this suggests the risks to GBP are now much more two-way; it will only take a couple of weak UK data points for the current hawkish exuberance to fade and GBP to move back lower,” says Patel.

However, analysts are wary that currency markets will send the Pound higher in anticipation of further pro-Sterling central bank rhetoric.

We saw the EUR show some convincing follow-through buying after Draghi’s remarks at the same conference.

As such, “there are short-term risks that the GBP/USD rally could extend to technical resistance in the 1.3050/3100 area.”

“That may mark the top for the time being;” says Patel. “If not - and we see a daily/weekly close above 1.3100 - a more significant re-assessment of the BoE hiking cycle may be underway and 1.35/38 cannot be ruled out.”

Concerning the Pound, a move back into recent ranges is expected.

Analyst Robin Wilkin at Lloyds Bank tells commercial banking clients a deeper sell-off in the Euro is possible.

Wilkin is watching for a potential rise to resistance in the 1.1416/1.1474 region noting that the range lows, highlighted in the above graph, have held.

His studies suggest the potential for levels in the 1.1628-1.1765 region to be tested.

Haldane Props up the Pound

The Pound and Euro’s central bank-driven gains appear to have held on Thursday, June 29 following supportive words being issued by the Bank of England’s Chief Economist, Andy Haldane.

Haldane told the BBC in an interview in Wales that the Bank of England would “look seriously at the possibility of raising rates” in order to defend living standards.

Haldane raised eye-brows in June with his suggestion that a 0.25% interest rate rise could be delivered without risking economic growth.