|BoE lending rate, % eop||0.25||0.25||0.75||1.00|
- We at Fitch Solutions are mildly positive on the outlook for sterling, projecting it will trade up toward the USD1.40/GBP level over our forecast horizon.
- Sterling should find support from an improvement in the global epidemiological situation and from the hawkishness of the Bank of England, though a return to pre-Brexit levels against the dollar is unlikely.
- Risks to our forecasts are tilted to the downside. Sterling is particularly vulnerable to a bout of financial market volatility given the UK’s large current account deficit.
Short-Term Outlook (three-to-six months)
We at Fitch Solutions are mildly positive on the outlook for sterling in the near-term, projecting it will trade up toward the USD1.38/GBP level on a six-month horizon. Sterling came under significant pressure in Q421 as the UK’s epidemiological situation deteriorated following the emergence of the Omicron variant of Covid-19, which prompted the government to introduce restrictions on activity in early December. Sterling is also highly vulnerable to shifts in investor sentiment as a result of the UK’s large current account deficit and a slip in risk appetite linked to the pandemic and concerns surrounding the persistence of inflationary pressures acted as a further headwind in the final quarter of 2021. The currency had, however, appeared oversold and it began to recoup some of its losses in late December as the backdrop for risk improved, with equities rallying globally.
Looking ahead, we see scope for sterling to extend its recent gains, given emerging data that shows Omicron, a key factor behind the Q421 sell-off, may be significantly less virulent than preceding variants. Indeed, it is striking that while case loads have spiked in the UK, numbers in intensive care remain well below prior peaks (see chart below). These positive trends, if maintained, should allow the pandemic to gradually recede as a key driver of economic activity this year, particularly given the simultaneous boost from vaccines and the availability of antiviral therapeutic treatments. This in turn would act as a boost to risk appetite, supporting sterling. In the near-term, the currency may also benefit from potential UK economic outperformance relative to expectations in Q122, assuming the government can maintain a loose containment regime despite the surge in infections. That said, it is worth stressing that trading conditions may be volatile in the quarter owing to the still elevated possibility of lockdown after increased household mixing at Christmas, as well as due to the uncertain outlook for inflation amid a still precarious energy situation in Europe.
Over H122, we expect sterling will also benefit from the hawkish stance of the Bank of England (BoE), which unexpectedly began its hiking cycle in December 2021 when it raised the Bank Rate by 15 basis points (bps) to 0.25%. A better than expected epidemiological situation and a potential pick-up in economic activity in January 2022 should give the central bank room to follow this with a further 25bps hike at its February meeting. This would pave the way for quantitative tightening to begin in March 2022, given the BoE’s own guidance that the process will commence when the Bank Rate hits 0.50%. We anticipate that quantitative tightening will result in a modest steepening of the UK yield curve, as a result of reduced demand for longer-dated bonds. Given the BoE is taking this step well ahead of peers such as the European Central Bank and US Federal Reserve, who are still expanding the size of their balance sheets, this move should help to boost sterling as a result of a more favourable interest rate differential.
Favourable Yield On UK Debt To Support Sterling
UK & US - 10-Year Government Bond Yield Spread, % & GBP/USD, exchange rate
We note that Brexit-related headlines do represent a source of volatility for sterling, but we believe that the backdrop has improved relative to H221. The UK government has adopted a more conciliatory position in recent months, which may have prompted the departure of David Frost as chief negotiator for the UK side. He has been replaced by Foreign Secretary Liz Truss, who is viewed as more pragmatic. The UK has dropped its opposition to the role of the European Court of Justice in overseeing the Northern Ireland protocol, though it remains opposed to the introduction of additional hurdles in Great Britain-Northern Ireland trade.
Long-Term Outlook (six-to-24 months)
We see scope for sterling to move modestly higher on a longer-term horizon, toward the USD1.40/GBP threshold that was briefly breached in mid-2022. However, we struggle to see the currency pair breaking back to pre-Brexit levels above USD1.45/GBP on a sustainable basis given weaker UK fundamentals. Granted, the abatement of Brexit and pandemic related uncertainty will act as a tailwind for the UK currency, but it is worth emphasizing that the limited trade deal that was agreed with the EU will do permanent lasting damage to the UK. Indeed, the Office for Budget Responsibility estimates that UK potential GDP will be around 4% lower in the longer-term than if Brexit had not occurred. Slower growth amid reduced access to the EU’s single market will serve to curb capital inflows, a headwind for sterling.
To an extent, the impact will be offset by the hawkish BoE, which we anticipate will raise its policy rate to 0.75% by year-end and to 1.25% by end-2023. We note that when the Bank Rate hits 1.00%, the BoE has indicated it will accelerate the process of balance sheet reduction by selling its existing holdings in the open market rather than simply ending the reinvestment of maturing bonds in its portfolio. An additional factor that will help to push the GBP/USD pair slightly higher is our view that the dollar will soften over the course of H222 as a result of less favourable fundamentals. We note that while the IMF estimates that in real effective exchange rate terms, sterling is 7.5% overvalued, the equivalent figure for the US dollar is 8.2%.
Risks To Outlook
Risks to our forecasts remain tilted to the downside, with sterling particularly vulnerable to a bout of financial market volatility. Of particular concern is the uncertain outlook for inflation. In the event that price pressures prove more persistent than expected, it is likely that central banks will begin to tighten monetary policy at a faster pace than the market is currently expecting. In the event of such an outcome, it is likely that equities and speculative-grade corporate credit, both of which are trading at lofty valuations after a prolonged period of accommodative monetary policy, could come under intense downward pressure. In such an environment, we would expect to see a flight to safety, with sterling likely to sell off sharply as it did in March 2020 when the pandemic struck.
This report from Fitch Solutions Country Risk & Industry Research is a product of Fitch Solutions Group Ltd, UK Company registration number 08789939 ('FSG'). FSG is an affiliate of Fitch Ratings Inc. ('Fitch Ratings'). FSG is solely responsible for the content of this report, without any input from Fitch Ratings. Copyright © 2021 Fitch Solutions Group Limited. © Fitch Solutions Group Limited All rights reserved. 30 North Colonnade, London E14 5GN, UK.