GBP/USD began 2021 under downward pressure. Interest rate markets in early 2021 were pricing negative interest rates for the Bank of England’s official cash rate (Bank Rate) because of the extreme weakness in the UK economy (see chart). The UK government made the decision to lockdown the UK economy in early January. The Bank of England subsequently notified banks and building societies to prepare for “the possibility” of negative interest rates.
GBP then began to strengthen in mid-February, as the UK economy re-gained momentum. GBP gained further ground over H1 2021 and reached its 2021 high of 1.4250 on 1 June, as the prospect of negative interest rates by the BoE dissipated, in line with improvements in the UK economy.
In the second half of 2021, GBP began to weaken. GBP’s weakness was most notable against the strengthening USD and appreciating CNY. As we entered the final quarter of 2021, GBP moved into negative annual performance against these two currencies. Some of the depreciation in GBP reversed following an unexpected interest rate rise by the Bank of England at the 16 December meeting. The BoE lifted the Bank Rate from 0.15% to 0.25%.
The depreciation in GBP against the USD and CNY over H2 2021 more reflects strength in the USD and CNY currencies, rather than weakness in the GBP per se. GBP held onto most of its 2021 gains against JPY, EUR, AUD, and NZD.
It is helpful to recognise that as the USD began to strengthen against most currencies in mid-2021, GBP/USD declined less than AUD/USD and NZD/USD over H2 2021. The fact that the UK government reduced Covid restrictions earlier than the Australian and New Zealand governments helps explains GBP’s relative strength.
GBP also rose against AUD because the RBA “disappointed the market”, which was looking for a more hawkish stance by the RBA at their November monetary policy meeting. Low Australian core inflation (2.1%) and a softer outlook for wage growth and the Australian economy justified the RBA’s policy stance.
GBP also rose against NZD in Q4 because of a softening in the New Zealand economy. The Reserve Bank of New Zealand had earlier lifted interest rates. However, New Zealand retail activity, consumer spending, and business confidence had begun to soften as covid restrictions impacted New Zealand economic activity. After a strong second quarter of GDP growth, the New Zealand economy contracted 3.7% in the third quarter.
In summary, the most notable feature about the UK economy, and reflected in GBP’s performance over 2021, was the rather radical change in market pricing for a Bank of England interest rate changes. From pricing Bank of England interest rate cuts and negative interest rates at the beginning of 2021, the interest rate market moved to pricing interest rate rises in Q4 of 2021, which the Bank of England subsequently delivered.
The outlook for GBP/USD over 2022 is likely to be driven in part by the interest rate rises priced by the market for both the Bank of England and for the US Federal Reserve. While the Bank of England revised down their UK real GDP growth forecast for Q4 2021 and Q1 2022, they noted that “the experience since March 2020 suggests that successive waves of Covid appear to have had less impact on GDP”. However, unlike the US economy, the UK economy has yet to regain its level prior to the beginning of the pandemic in March 2020 (see chart).The USD over 2022 will be guided by how far the Fed believes it needs to lift interest rates. At the moment, there appears a larger risk that the Fed lifts interest rates more than the Bank of England over 2022. However, almost certainly there will be periods where GBP will appreciate against the USD. When this strength in GBP inevitably occurs, it is worth keeping in mind that GBP/USD has struggled to spend much time above 1.4200 since the U.K’s Brexit decision in mid-2016.
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