Something a bit weird is happening in currency and rates markets at the moment and while not momentous, the moves of the next three or four weeks will govern how sterling trades through the last quarter of this year and well into 2022.
Any international business needs to be aware of the situation that is currently bubbling up in sterling markets.
What is the Bank of England doing?
The Bank of England typically sits between the Federal Reserve and the European Central Bank when it comes to policy timing. The Fed will lead the G10 out of a recession – like they did following the Global Financial Crisis that began in 2008 – then the Bank of England will come along, and the European Central Bank will never get round to exiting their stimulus programs.
We are seeing a marked change in this timing currently however, with markets having to price in a Bank of England rate hike before the Fed in Washington takes the plunge next year.
For us, that seems strange given everything that is going on in the UK at the moment; the end of furlough and pandemic financial support measures, a petrol crisis, record natural gas prices, supermarket shelves empty on supply chain concerns, Brexit negotiations, rising inflation, another winter of Covid-19 and tax rises.
How much have expectations changed?
A fair bit. You’d have to go back to December 2019, to the days just after Boris Johnson won a resounding victory in the general election for expectations on interest rates to be as optimistic as they are now.
And the further out the curve you go, the more aggressive the tightening has become. At the beginning of the year, expectations were that the Bank of England base rate would remain at zero all the way until December 2022, with rates only increasing to 0.3% by September of the following year.
Markets are now forecasting rates to rise next month and to a full 1% by December of next year. The last time the Bank of England base rate was that high, Barack Obama had just become US President, Taken was the big movie in the cinemas and Lady Gaga’s debut single “Just Dance” was topping the charts.
It was February 2009 and rates were on their way to, at the time, an historic low.
What does this mean for sterling?
A lot of people will say currencies rise when interest rates go up. In a textbook or a classroom that argument makes sense; investors want the higher rate paid for holding that currency and buy it, causing its value to rise.
In real life however, central banks don’t raise rates without preparing the ground first. There are speeches, interviews with journalists, briefings with economists and webinars online. It therefore stands that currencies rise on the EXPECTATION that interest rates will rise and then decline once the event has taken place.
We are in that expectation phase now until we get to November 4th and the next Bank of England meeting.
The issue that we see sterling having is that with these historical interest rate expectations it is not really outperforming other currencies. Expectations only started to harden on September 23rd as the Bank of England highlighted that inflation may drive above 4% this year.
Despite that and since then, sterling is 2.2% lower against the Canadian dollar and 0.5% weaker against the US dollar.
Sterling’s strength is flagging already and with all the issues that the UK economy is facing currently it is solely these rate expectations that is keeping the pound from deteriorating further.
What do we expect?
With a rate rise of 10bps (0.1% in old money) almost entirely priced in next month we will see in the coming days whether the Bank of England is happy with such expectation or would prefer instead to push back against a market that may have got the wrong end of the stick.
While these expectations remain solid however, we can foresee a level of sterling support at current levels although any aggressive moves higher remain less likely. If, of course, the Bank fails to raise rates or communications from Threadneedle St convince markets that an increase in the cost of borrowing is not on the cards currently then the pound’s singular engine of support will fail and GBP could trade like a lift with the cord cut.
What can I do?
First of all, you have to know where and when currency movements and risks hit your business. Doing a thorough audit of how these pressures affect your business and finances.
Secondly, decide your risk appetite. Are you prepared to gamble on currencies and hope that rates go in your favour as much as they go against you? Or would you prefer to focus on your business and ensure that margins are protected?
Lastly, speak to an expert. Even a half hour conversation with a specialist currency provider is enough to put in place a simple policy that can alleviate currency pressures on your business.
Sterling is not the safe haven currency it used to be and is going to have to navigate some pretty choppy seas in the coming months. Sterling is not a predictable currency at the best of times and we are most certainly not in the best of times.