The pound is on the back foot against the euro and is likely to remain in a weaker position into the New Year after last week’s interest rate increases in the UK and Europe. With inflation still running high, growth slim and a real threat of recession in the year ahead, the fact that Europe is doing slightly better, although it is still far from healthy, will work in favour of a stronger euro against the pound.
The Bank of England’s decision to raise rates by half a percentage point was not much of a surprise as the bank responded to high post Covid, post war in Ukraine inflation. November inflation of 10.7%, though marginally lower than in October, is a far cry from the government’s long-term target of 2% and paves the way for further hikes in 2023 with rates widely expected to reach at least 4.5% before the end of this cycle.
The split of the monetary committee with six in favour of a hike and three against, makes a February increase very likely. The ECB sang a similar tune this week, raising rates to 2% and promising further increases down the road. Unlike the Federal Reserve, which seems to be pivoting away from further hikes, the ECB has already said it expects to raise rates in February and then in March.
The pound weakened 1.5% straight after the central banks’ decisions and continued to weaken the next day as yields for short-term bonds in Europe jumped up in contrast to the UK where gilt yields weakened.
Looking ahead
The economic tea leaves are not particularly encouraging for the UK where the economy is teetering on the brink of recession and the country maintains a long running budget deficit.. The pound also remains sensitive to trends in the equity markets and tends to move very broadly in sync, rising when equities rise and selling off when equities decline.
In the third quarter the UK economy shrunk by 0.2% compared with the EU’s expansion of 0.2%. Composite PMI numbers for both regions are still below the key 50 reading that would indicate a recovery, but one positive sign for both regions is that the numbers were marginally better than markets had expected a few weeks ago.
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According to research by investment bank ING the contraction in the Eurozone economy in December was likely mild for both the manufacturing and services sectors. Manufacturing output declined less than expected as the drop in new orders eased a bit. Very importantly though, delivery times improved for the first time since the start of the Covid pandemic as supply chain problems eased because of low demand for inputs and improvements in production. For services, new business continued to contract at a similar pace as last month.
Looking at the dollar, the outlook in the short term is far more positive with the greenback expected to rally back to its recent highs before consolidating later in the first quarter. But the potential end of the rate rise cycle, stronger growth dynamics and a more stable yield environment are likely to dampen the dollar’s performance further ahead.
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