Markets Insight From IG

13 Nov 2017 | 11.19 am

Markets Insight From IG

Sterling's fate depends on how the UK's Brexit negotiations will pan out

13 Nov 2017 | 11.19 am

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After the Bank of England decision to increase bank rates, the fate of sterling revolves around how the UK’s Brexit talks pan out, writes Martin Essex (pictured), Analyst and Editor of IG’s free news and research site, DailyFX.com

The Bank of England’s decision on November 2 to increase UK Bank Rate for the first time in more than ten years leaves traders in the pound against the euro and other currencies free to concentrate on the Brexit negotiations rather than UK monetary policy.

After raising the benchmark rate to 0.5% from 0.25%, the Bank said any further increases would be “at a gradual pace and to a limited extent”, suggesting extreme caution: it is not inclined to hike rates further while UK economic growth remains underwhelming. The market now expects  just two more quarter-point rate increases over the next three years.

If monetary policy is therefore on the back burner, the progress of the Brexit talks between the UK and the EU is likely to be the principal driver of the pound in the months ahead.

If so, the equation is straightforward: steps towards a deal or agreed transition period should be positive for the pound, while setbacks should be negative. If the Brexit talks go badly and “no deal” becomes increasingly likely, this will make the Bank even less inclined to tighten UK monetary policy, magnifying the downward pressure on sterling.

In the UK budget on on November 22, it is possible that Chancellor of the Exchequer Philip Hammond will decide to ease fiscal policy after years of austerity. Any major loosening, through  tax cuts or extra spending, could make the Bank of England more inclined to tighten monetary policy in response, however unlikely that now seems after the bank’s ‘dovish hike’.

Meanwhile, in the European Union and the United States, monetary policy is being tightened: in the US through higher official interest rates and in the eurozone through what is known as ‘tapering’ — or reducing — the European Central Bank’s bond-buying programme.

The logic is that the economic picture has brightened, so less stimulus is needed. However, there is one major difference. In the US, the yield on 10-year government bonds at the time of writing was close to 2.4%. In Europe, the yield on 10-year German government bonds was less than 0.4%.

For a Japanese investor, the investment choice is obvious: you would invest in the US to take advantage of the higher interest rates. So, the dollar has been strengthening against the euro as our hypothetical Japanese investor needs to buy dollars to invest in the US. Except that it hasn’t. In fact, the euro climbed from close to $1.05 at the start of the year to above $1.20 at its peak in early September, before easing back a little in late September and October.

Market Expectations

Markets react to what is expected to happen, not to how things are right now. The US has already begun to increase official interest rates, so that is already reflected in market prices. By contrast, in the eurozone, the tapering of monetary stimulus has yet to begin, and the euro’s advance from January to September quite probably reflected the growing expectation that policy would be tightened.

The ECB recently announced that it will halve its bond buying to €30bn per month from January 2018. It is quite possible that the euro will extend its decline against the dollar that began in early September, particularly as the ECB has made clear that there is no likelihood of it raising official interest rates anytime soon.

 

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