Dovish BOE sends GBPUSD to lowest since mid-2020

Today, the Bank of England raised interest rates by yet another 25 basis points (bps) to bring its benchmark rate up to 1%.

The BOE has now hiked at four consecutive policy meetings, starting from its December hike.

Yet, the Pound is falling, even though a rate hike typically translates into a stronger currency. 

Sterling is weakening against all of its G10 peers today, with GBPUSD now trading around the 1.24 mark..

 

So why has Sterling been falling?

The Pound's weakness is largely because markets think the Bank of England cannot raise rates much higher from current levels without breaking the UK economy.

 

Before we go any further, a reminder that in this zero-sum game in the FX world, one currency’s value is judged relative to the other. In GBPUSD’s case, it’s the Pound’s value vs. the US dollar.

And in this post-pandemic era, markets have largely been determining the values of many G10 currencies based on which central bank can raise its interest rates higher or faster relative to another central bank.

The central bank that’s deemed more capable to send its rates higher = stronger currency.
(in turn, investors have less demand for the currency of the central bank that's relatively slower at raising rates)

The above equation has arguably been the single biggest factor influencing the performance of G10 currencies of late.

 

Which brings us to today’s BOE announcement …

The Bank of England today highlighted the risk of a recession in the UK, which suggests the economy may be unable to withstand interest rates going up much further from here (despite today’s 25bps hike).

BOE policymakers expect the economy to shrink by 1% in Q4 2022, while 2023’s GDP is set to contract by 0.25%.

The forecasted economic contraction is due to the rising cost of living, which translates into UK households having less to spend and keep the economy growing.

Note that UK inflation in March 2022 had risen by 7% compared to the same month last year (March 2021). This was already its fastest rise in consumer prices since 1992!

Looking ahead, the BOE expects UK inflation to go into the double-digits in Q4 this year!

Hence, the impetus for the BOE to raise interest rates.

 

A recap of how interest rate hikes typically help subdue inflation:

When interest rates go higher:

= it becomes more expensive for UK businesses/households to borrow money

= less money available to be spent in the economy

= less demand

= businesses are prompted into lowering their prices in order to find a new equilibrium with the lower demand

= slower inflation

and that's in an ideal textbook scenario.

 

However, things can go very wrong with rate hikes too.

When interest rates go higher:

= it becomes more expensive for UK businesses/households to borrow money

= less money available to be spent in the economy

= less demand

= economic growth slows down, or worse, the economy enters a recession!

 

Hence, the BOE is facing an almighty dilemma:

Does the BOE:

(A) hike interest rates in order to bring down consumer prices at the risk of triggering a recession?

or ...

(B) slow down/limit its rate hikes to try and give the economy fighting chance, but risk inflation spiralling out of control?

 

Markets now think the BOE has to lean closer to option (B), hence the drop in Sterling on Thursday.

 

What about the USD side of GBPUSD?

The US dollar's performance this week had been primed to react to the US central bank's latest policy signals.

Here's a recap on the latest Fed decision.

The US Federal Reserve also signalled a more-dovish-than-expected message yesterday, despite hiking its own benchmark rates by another 50 basis points - a move that had been widely anticipated already.

On Wednesday, Fed Chair Jerome Powell appeared to pour cold water on the prospects of a 75bps hike - a scenario that markets had given up to a 40% chance of happening in June, with such hawkish bets translating into a stunning surge for the US dollar.

A 75bps move would be massive, considering that a central bank typically adjusts its rates higher or lower by 25bps at a time.

So, imagine the Fed firing 3 bullets with a single shot to try and vanquish the inflation beast.

Instead, Chair Powell suggested that the Fed would instead be more comfortable with hiking rates by “only” 50 basis points (still a 2-in-1 shot) at each of its next three policy meetings, scheduled for June, July and September.

As a result of that relatively dovish message (dovish relative to what markets had expected), the US dollar saw a mid-week pullback from recent heights as markets lowered their bets for a 75bps hike in June.

 

It's all relative: BOE “outdoves” the Fed

So as things stand, despite two relatively dovish announcements out of two major central banks this week, the Fed still appears more hawkish compared to the BOE.

Hence, markets "punished" the currency of the more dovish of these two central banks on either side of the Atlantic, which sent GBPUSD plummeting to its lowest levels since mid-2020.

And if this disparity persists between either side of the Atlantic, that should ensure that the Sterling maintains a bias to the downside, while potentially having a very tough time paring back its losses against the US dollar. A path towards 1.20 may prove likelier for this currency pair known as 'cable', rather than a path back up to 1.30.

Overall, the Pound should find it easier to move lower, especially as the risk of a recession looms larger for the UK economy by the end of 2022.