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Annual review: After a mixed 2021, where is the pound heading?

Annual review 2021: GBP - The Bank of England

It’s been a year of two halves for the pound. Sterling came into this year on the up – after sinking last year to a 35-year low of 1.1412 against the US dollar, it finished 2020 at the 1.3600 level. 

The upward trend continued into 2021, despite concerns over negative rates and the start of a third national lockdown from 6 January, culminating in a peak of 1.4249 on 1 June. The pound reached the halfway point of the year on a buoyant note, its strong performance attributable to what we might call “a vaccine premium”, as the UK led the way in vaccinating its population. 

However, the second half of this year wasn’t as positive. The pound fell gradually from that June peak to a year-to-date low of 1.3160 in early December, as the benefits of the vaccine premium faded. 

The pound’s decline has mainly been due to the strength of the US dollar, rather than sterling weakness, as shown in the chart below. Mind you, there have been days when sentiment around the pound has been profoundly negative. 

GBP performance comparison chart (2021)​

Source: CMC Markets

The pound’s performance against the likes of the euro, Japanese yen, and Swiss franc has been much better, reminding us that if we look at the pound solely in terms of its performance against the US dollar, we may get an incomplete picture.

One welcome development this year has been the lack of predictions of parity against the euro and the US dollar, a consistent staple in recent years. That said, tired attempts to liken the pound to an emerging market currency still got the occasional airing. 

Another factor that weighed on the pound at the start of the year was the prosect that the Bank of England might be looking to introduce negative interest rates. Several policymakers seemed enthusiastic about this idea, with the central bank pushing the banking sector to prepare for such an outcome, even though negative interest rates have been ineffective in countries where they have been introduced, including parts of the EU, Switzerland and Japan. 

The rationale behind lowering interest rates into negative territory is that it would help stimulate consumer spending, as well as investment. Proponents of negative interest rates claimed that the policy worked in the EU and Japan, where rates remain at record lows. This reasoning crumbles under closer scrutiny. Banks in both the EU and Japan have struggled to give negative-rate loans away, and also struggled to generate any sort of margin on their lending operations. Consumers are highly unlikely to spend on anything other than essentials if they are worried about catching an infectious virus or losing their job as a result of an economic shutdown. 

Fortunately, as the economy has improved this year, the monetary policy debate shifted from negative rates towards the question of when interest rates might move higher. 

This is illustrated by movements in UK gilt yields since the start of the year. At the end of 2020, UK two-year gilts had a negative yield of -0.16%. Since then, the yield has risen bit by bit, reaching a high of 0.733% in October. The current rate sits just below 0.6%. Given that the base rate is at 0.1%, this is quite a significant shift in sentiment and expectations. It begs the question, what can we expect over the next 12 months? 

Where next for the pound?

As we look ahead to 2022, the big question now is whether the Bank of England will deliver on a modest increase in the base rate. If they do, that raises the question of how many more hikes might follow over the course of the next 12 months.

Markets are pricing in the prospect of a base rate of 0.75% over the next 18 months. But is that credible? To many it seems mightily optimistic. While we could see rates rise in the coming months, markets may need to temper their expectations.

A rate rise won’t necessarily boost the pound, especially if other central banks move in a similar direction. Rate hikes elsewhere seem possible, with many economists voicing concerns that the US Federal Reserve is behind the curve in guiding expectations around its monetary policy direction. 

The US central bank is currently tapering its bond-buying programme by $15bn a month, of which $10bn is being cut from purchases of US treasuries, with $5bn being trimmed from purchases of mortgage-backed securities. However, there are calls for this process to be accelerated, which would bring rate-rise expectations forward. Consequently, financial markets are pricing in the prospect of two US rate rises by the end of next year. 

Similarly, the pound has not been helped by the Bank of England’s management of market expectations, which has been nothing short of woeful. In early November the UK’s central bank kept the base rate at 0.1%, despite having appeared to foreshadow a rate rise in the weeks leading up to the decision. The central bank is now suffering from a credibility deficit and will need to work hard to rebuild trust next year. 

Sadly, this behaviour fits a pattern. When Andrew Bailey was appointed governor of the Bank of England in March 2020, it was hoped that the central bank’s communication strategy might improve, after the mixed messaging under Bailey’s predecessor Mark Carney. Having repeatedly hinted at interest rate rises without following through, Carney was labelled an “unreliable boyfriend” by Labour MP Pat McFadden during a House of Commons Treasury select committee in June 2014. Sadly, clarity of messaging seems to have worsened even further, with the bank seemingly ambivalent about improving it. That needs to change in 2022. 

Meanwhile, the outlook for the euro remains tilted towards the downside. The president of the European Central Bank, Christine Lagarde, has said that it is unlikely the eurozone will increase interest rates next year from their current levels of -0.5%, despite concerns over rising inflation. This stance has weighed on the euro throughout 2021 and could continue to do so in 2022. 

The ECB is correct to point out that core CPI is much lower in the EU than it is in the US or UK. However, regional disparities mean that inflation is likely much higher in countries like Germany, and below the eurozone average in southern European countries. 

Direction of pound to be shaped by central bank policy, pace of recovery

Despite sterling’s weakness against the dollar in the second half of 2021, there is decent support for the pound in the low 1.3000s, as shown in the long-term monthly chart below. 

The 200-month moving average remains a key draw for the price action, while the 50- and 100-month moving averages could see a fall back towards 1.3200. 

The chart shows that the 1.4200 mark – as indicated by the horizontal white line – is a huge resistance level, with the pound this year failing to move above the previous peak from 2018. 

GBP/USD monthly chart (1991-present)

Source: Bloomberg

This sort of technical analysis tends to be greeted with scepticism by some, and while there are no absolutes when it comes to analysing price moves, we can still discuss probabilities based on precedent.

After another 12 months of price action, the GBP/USD rate has risen above the 50-month moving average, which should provide some element of support. 

However, the pound’s failure to move above the 2018 peak of 1.4200 raises the risk of a fall towards the previous lows, but that could only happen if we unexpectedly drop back below the 50-month moving average at 1.3200. 

Working on the basis that prices eventually revert to their longer-term mean, the bias remains for an increase towards the 1.4000 level, especially as we are still some way off the 200-month moving average, which has now fallen to the mid-1.5000s. 

While the long-term monthly chart suggests that the pound may be settling into a new range between the recent lows of 1.2000 and the peak this year of 1.4250, the daily chart, below, is a little less clear. Worryingly, it looks a little on the soft side, currently showing a downtrend from the June highs.

GBP/USD daily chart (March-December 2021)

Source: CMC Markets

Looked at on this basis, there would need to be a move below the 1.3200 area to undermine the current upward momentum that has been in place since the end of Q2 2020. On the upside we need to see a break of the upper line as well as the 200-day moving average to alleviate the current downside pressure on the cable price. 

Ultimately, the direction of the pound in 2022 will depend on a variety of factors, including the speed of any economic recovery central bank policy, and fiscal measures taken by governments. There will likely be concerns heading into the next tax year if the economy is still struggling and the UK government goes ahead with its planned tax increases.

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