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Pound likely to remain under pressure this year

We think the Bank of England will hike interest rates by less than money markets now discount, which in turn should keep the pound under pressure against the dollar.
  • Fed’s July meeting minutes likely to emphasise commitment to further hikes (Wed. 19.00 BST)
  • We expect the Norges Bank to raise its policy rate by 50bp to 1.75% (09.00 BST)
  • Turkey’s central bank will probably leave its one-week repo rate on hold at 14% (12.00 BST)

Key Market Themes

We think the Bank of England will hike interest rates by less than money markets now discount, which in turn should keep the pound under pressure against the dollar.

Our UK economics service is the place to look for detailed analysis of the raft of UK data releases published this week. But, in short, they have showed that while inflationary pressures might be dropping back elsewhere, notably in the US, they are still rising in the UK. Indeed, June’s labour market data released on Tuesday revealed that another leap in wage growth. And CPI data for July, released this morning, registered yet another surprise to the upside.

The reaction in bond markets following both releases has been significant. The yields of 10-year and 2-year Gilts having risen by over 25bp and ~40bp, respectively, over the past few days. (See Chart 1.) But this has not fed through to the pound, which has weakened against the dollar.

Chart 1: UK Gilt Yields (%)

Sources: Refinitiv, Capital Economics

The sell-off in bond markets mostly seems to reflect the upward shift in investors’ expectations for the peak in Bank Rate in this tightening cycle. (See Chart 2.) That said, investors continue to anticipate a quick turnaround in policy from rate hikes to rate cuts. That can also be seen in the recent inversion of the 10-year/2-year portion of the yield curve. While this doesn’t have the same track record as a recession indicator as it does in the US, it still indicates that investors anticipate the Bank reversing course fairly quickly next year.

Chart 2: Bank Rate (%)

Sources: Refinitiv, Capital Economics

That’s broadly similar to what is currently priced in for the Fed’s “pivot” next year – both with respect to the timing of the suspected turnaround and the pace of it. But there is also a key difference. Whereas investors’ interest rate expectations in the US are broadly in line with the guidance from the median dot in the Fed’s most recently published set of dot plots and our own forecasts, they are much higher in the UK than what can be inferred from the Bank of England’s latest projections (at its meeting earlier in August, the Bank suggested that inflation would, eventually, fall below the 2.0% target at the market implied path for Bank Rate – back then it peaked at 3.0%) and our own forecast for Bank Rate. (See Chart 2 again.)

As such, we suspect that investors have probably got a bit ahead of themselves by expecting the Bank of England to raise rates to closer to 4.0% and, ultimately, will have to pare back those expectations in time. If we are correct in this view that there will be a bit less tightening in the UK than investors anticipate, but that they are broadly correct about the degree required in the US, that is another reason to think that the pound might continue to remain under pressure against the dollar. Our forecast is that the pound will edge lower to $1.18/£, from ~$1.20/£ currently, and the risks to that forecast are increasingly to the downside (Kieran Tompkins)

Selected Data & Events

BST

Previous*

Median*

CE Forecast*

Thu 18th

Nor

Interest Rate Announcement

09.00

1.25%

1.75%

1.75%

*m/m(y/y) unless otherwise stated; p = provisional


Key Data & Events

US

Although headline retail sales were unchanged in July, that partly reflects the drag from lower gasoline prices, with the details suggesting that overall consumption rose fairly strongly in real terms last month. Alongside upward revisions to previous months’ readings, the data leave consumers looking in slightly better shape than previously thought and support our view that GDP will rebound by at least 2% annualised in the third quarter. Later on Wednesday, the minutes from the Fed’s July meeting are likely to reinforce the idea that officials remain committed to continuing to raise interest rates over the rest of this year. (Andrew Hunter)

Europe

The chunky 0.6% q/q rise in euro-zone GDP in Q2 reflected the re-opening of the services sector and was accompanied by a further increase in employment. But a combination of high inflation, rising interest rates and the energy crisis will push the economy into recession before the end of this year. The detailed breakdown of euro-zone inflation in July (due Thursday) will tell us more about the breadth of price pressures in the currency union.

In Norway, we expect the Norges Bank to raise its policy rate by 50bp on Thursday, to 1.75%. That would be a bigger increase than it signalled at its last meeting, but would be justified given the strength of inflation. It is likely to state that further rate hikes will follow at forthcoming meetings.

In the UK, the rise in CPI inflation from 9.4% in June to a new 40-year high of 10.1% in July was the eighth upside surprise in the past ten months. Together with June’s leap in earnings growth, we think this raises the chances that the BoE will opt for a 50bp interest rate hike on 15th September, rather than 25bp. (Jack Allen-Reynolds & Nicholas Farr)

Other Developed Markets

The 0.7% q/q rise in Australia’s wage price index was a bit weaker than expected but still lifted annual growth from 2.4% to 2.6%, the strongest it has been since 2013. With the minimum wage rising by 5.2% on 1st July, we expect wage growth to surpass 3% in Q3. Meanwhile, the RBNZ hiked its policy rate by 50bp as widely anticipated and signalled another 50bp hike at the upcoming meeting in October. With the Bank prepared to create a sharp slowdown in activity to rein in soaring inflation, we have revised up our forecast for the peak in the overnight cash rate from 3.5% to 4.0%.

Japan’s trade deficit widened to a record high in July. However, since most of that widening was driven by soaring import prices, we estimate that net trade will provide a 0.2%-pts contribution to q/q GDP growth in Q3. What’s more, the deficit should shrink again before long as the recent rebound in motor vehicle production will continue to support exports and commodity prices should ease further. (Marcel Thieliant)

Other Emerging Markets

We expect the central bank in the Philippines to hike interest rates by another 25bp on Thursday. As inflation reached a four-year high of 6.4% in July, we have further hikes pencilled in for September and November.

In Latin America, GDP data released on Tuesday showed that Colombia’s economy expanded by a robust 1.5% q/q in Q2. Strong growth, alongside upside inflation surprises and the fragile external position, mean that the central bank’s tightening cycle has a bit further to run. We expect the policy rate to be raised to 10.50% by October (previously 9.50%), from 9.00% now. GDP figures on Thursday are likely to show that Chile’s economy posted a small recovery in Q2, expanding by ~0.2% q/q. That said, surging inflation and tight monetary and fiscal policy are likely to push the economy into a recession over the second half of this year.

In Emerging Europe, Q2 GDP figures showed that Hungary and Romania expanded strongly in Q2 by 1-2% q/q, but the economies in Czech Republic and Slovakia barely grew at all and there was a shocking 2.3% q/q contraction in Poland. Looking ahead, we think that a number of economies will fall into recession later this year, or at best stagnate until early 2023 due to growing domestic and external headwinds. Tightening cycles are likely to come to an end too and today’s GDP release is likely to mean that further interest rate hikes in Poland are unlikely. On Thursday, we expect Turkey’s central bank to leave its one-week repo rate on hold at 14% despite the latest rise in inflation to ~80%.

Finally, June hard activity data out of South Africa suggest that the economy contracted by around 1.0% q/q in Q2, and we think that activity will remain weak in the coming quarters too. Meanwhile, the resignation of Egypt’s central bank governor Tarek Amer points to a growing tension within policymaking circles on the best way to address the country’s external imbalances. We think the next governor will ultimately need to let the pound depreciate more and hike interest rates further. (Liam Peach, Kim Sperrfechter, Virág Fórizs, Jason Tuvey)


Published at 17.13 BST 17th August 2022.

Editor: John Higgins, john.higgins@capitaleconomics.com
Enquiries: Harry Chambers, harry.chambers@capitaleconomics.com

Kieran Tompkins Assistant Economist
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