The usually timid Bank of England shocked markets with a 0.50% interest rate hike yesterday, taking the base rate to 5%. Yields on gilts rose as a result but GBP moves did not follow, with very similar price action following last week's overshoot on inflation. As we know, higher interest rate expectations have made GBP the best performing currency in the G10. But, focus now seems to be on concerns of the impact of further tightening on the UK economy, and particularly the property market.
Fed Powell maintained his stance that more rate hikes are needed in order to get to their inflation goal. Two Fed members added to this view, providing impetus for markets to start to back the USD again.
* Daily move - against G10 rates at 7:30am, 23.06.23
** Indicative rates - interbank rates at 7:30am, 23.06.23
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So where now for GBP? Ultimately it will come down to whether markets continue to focus on the short term and chase the higher yield that GBP assets can offer, or focus on the longer term concerns of higher interest rates on the economy. Yesterday’s price action seems to suggest there is doubt in chasing GBP higher, particularly now that we could be at the peak of where markets think UK interest rates will go to - we’ve seen similar price action on USD and EUR in recent months for the same reason. To me it seems the issue of rising borrowing costs and the damaging impact on households and the economy will be the likely focus for markets when it comes to GBP.
With focus in the markets turning from chasing yields to growth, today's PMI numbers will give a good gauge in terms of how each economy is doing. The EURhas turned negative already this morning, with French PMI numbers suggesting that their services and manufacturing sectors contracted in June. US Treasury Secretary Janet Yellen spoke last night suggesting she sees a lower chance of a recession from the US this year. This seems be boosting demand for USD as well.
Markets continue to price in the prospect of seeing interest rates rise to 6% - levels last seen in 2000. The case for a soft landing of the UK economy seems to be reducing, with households set to face a squeeze on household income. Since March 2022 the average 2-year fixed mortgage rate has trebled to 6%. According to the Institute for Fiscal Studies, based on current rates, the cost of the average mortgage will rise by £280 a month, which is twice the increase from average energy bills seen after the war in Ukraine began. We’ve already had two years of declining real incomes - a mortgage squeeze will add to this further and we have to ask ourselves, how much will this damage the economy? If talk of a UK recession becomes a dominant market narrative, then it will be tough for GBP to hold onto gains over the course of this year.
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