Cable has trended lower lately, becoming the worst-performing major currency. And that’s even considering that the dollar weakened. So, does that mean The Pound (GBPUSD) will continue to trend lower? Or has it finally reached bottom, and it’s time to recover? Let’s look at some of the fundamental reasons for the shift.
The pound’s relative weakness is noteworthy given the context of the Euro becoming significantly stronger. In fact, the EU’s common currency has risen so fast recently that ECB officials are starting to get concerned. The BOE has no such problems. What’s going on?
It’s the Economy
One of the key differences between the UK and the EU at present is that the ECB has effectively reached the end of its easing cycle. It might cut again if the currency appreciates too much, but given the current data, the consensus among economists is that there will be no more rate cuts for the rest of the year.
However, inflation has been persistently higher in the UK for several reasons. Most proximally, the recent hike in national insurance and energy prices has put a crimp on UK businesses. A tight labor market with wages growing faster than inflation has allowed businesses to pass on the bulk of those extra costs to consumers. This resultant higher inflation means that the BOE can’t justify rate cuts for now. But those higher costs also mean business activity is suffering, slowing down the economy.
Higher Rates Don’t Lift the Currency Anymore
Normally, higher interest rates increase investor demand for a currency. That’s because, everything else being equal, they can get a higher return for their investment. But if the economy is expected to slow down substantially, then the higher interest rates lose their charm. And since elevated rates are usually a drag on the economy, this could mean that if the interest rate gap gets too big, it starts to have the opposite effect on the currency.
The US and the UK are currently in a similar predicament, with both having relatively high interest rates and weakening currencies. Although central banks are currently keeping rates high, the consensus is that they will eventually have to lower them. Once the economy starts to sputter, then inflation can quickly turn around. And that will leave the central banks cutting rates at a fast clip, weakening the currency.
What to Look Out For
Markets are now pricing in two rate cuts from the BOE, compared to none from the ECB. Which means traders are discounting The Pound (GBPUSD) in anticipation of those easing moves. What could rescue The Pound (GBPUSD) in the current situation is if there is some reason for the BOE not to make those expected cuts.
Primarily, that would rely on a growing economy. GDP figures could take over in terms of influence on the economy instead of inflation in the short term as traders try to figure out if the BOE will be able to ease.