The pound’s rally might not occur again in 2H23

The market is pricing up another 150 basis points of UK rate hikes over the coming year.

At the start of the year, when the pound was trading around 1.20 against the dollar, the Standard Bank was projecting 1.26 by mid-year, while the median forecast in the Bloomberg survey of analysts was stuck at 1.20. For euro/sterling, which started the year around the 0.8850 level, its six-month call was for a modest rise in sterling to 0.87 compared to the Bloomberg median of 0.88. In the event, sterling has risen as expected against the dollar and even more against the euro. But while the bullish view might be paying dividends so far, it has become a little more cautious.

For instance, at the start of the year, the Standard Bank had a sterling/dollar one-year forecast of 1.34, but if you look at its 6-month forecast today, the year-end target has come down a bit to the 1.32 level. That still represents a decent gain for the pound, but we see a weaker US dollar as the US rate-hiking cycle ends, and we are not convinced that sterling can continue to make strong gains against other currencies such as the euro and the yen.

To see this, we first need to determine why the pound has performed so well this year. The Standard Bank put it down to two factors: elevated rate-hike expectations in the UK and positioning. On the former, there is no doubt that UK rates and rate expectations have moved well ahead of anything we’ve seen elsewhere. For instance, if we look at real 5-year yields in the UK and Germany and use 5-year forward-starting 5-year inflation swaps as our proxy for inflation expectations, then you see that the UK’s advantage has risen to near 100 bps from around zero at the start of 2023.

In terms of rate expectations, the market is pricing up another 150 basis points of UK rate hikes over the coming year, but a much more modest 50 basis points from the ECB. At the start of 2023, the market was assuming 100 bps of rate hikes from the BoE during the year but almost 150 bps from the ECB.

In other words, expectations have changed significantly, and while market pricing could prove incorrect, there seems little doubt that rate expectations have played a big part in sterling’s rise, at least against the euro. FX positioning may also have been a factor, as the autumn 2022 Liz Truss premiership debacle seemed to scare investors away, certainly in gilts, and may have caused traders to become structurally short of sterling.

For instance, data from the CFTC shows that non-commercial (speculative) traders have built up large, long euro-dollar positions, but the number of long sterling/dollar positions has been far smaller and actually showed net-short sterling positions up to mid-April. With the FX market appearing to be relatively short of the pound, it is perhaps little wonder that there has been some catch-up, which has led the pound not just to outperform the dollar but other currencies as well, such as the euro. Looking ahead, there are two problems.

The first is that the lift from bearish-sterling re-positioning seems likely to peter out, if it has not already.

The second factor relates to rates. In the Standard Bank's view, one of two things will happen, and neither is good for the pound. The first is that base rate hikes will fall far short of what is priced into the market. This is the Standard Bank’s base case scenario and something that could weigh on the pound. A second possibility is that base rates do indeed rise to the 6.5% region as the market expects, perhaps more.

In theory, this might seem like good news for the pound, as higher rates mean a higher currency, but, as we all know, there comes a point when higher rates no longer help the currency. For instance, "excessively" high rates might cause investors to grow concerned about the economic damage or the threats to the budget from increased financing costs. Foreign investors already seem more wary of gilts. Putting all this together suggests to us that we won’t see a repeat of the rally in the first half of this year in the second half—except perhaps against the dollar.