In our last take on the British pound in early January, we wrote that the currency was set to keep strengthening thanks to strong regional growth, moderate sentiment and the historically low value of the pound. More specifically, the currency looks cheap based on broad nominal effective exchange rates (a measure of the pound relative to other foreign currencies). Looking at GBP/USD since our last commentary, the pair strengthened from around 1.35 to above 1.41 today. Looking at the pound now, sentiment is looking a lot more stretched, and the currency is at risk of a short-term correction in the near future. In a recent commentary, we highlighted how buying British pounds has become a consensus long position. Over the longer-term, we continue to believe that the pound can keep strengthening. Specifically, expectations for tighter monetary policy is an additional factor that should drive the pound to new highs over 2018.

Monetary policy re-emerges as a factor to watch

Following the Brexit referendum vote, markets expected the Bank of England to ease (weakening the pound). While headline inflation surged towards 3%+, few expected the BoE to hike rates into a slowing economy. The prospect of stagflation (high inflation during slow growth) is a central bank’s worst nightmare. Prior to the referendum, BoE Governor Mark Carney warned that a successful Brexit vote may result in a recession. Many leading banks and the UK government itself published similar forecasts. Thanks to the underlying resilience of the British economy and a global upturn starting in early 2017, the doomsday forecasts failed to come true.

Today, Carney’s tone is decidedly more optimistic. In a testimony delivered earlier this week to the House of Lords Economic Affairs Committee, Carney forecasted higher real wage growth this year. He also stated that he was positively surprised by the “degree of churn” in the labor market, an indication of economic confidence. Lastly, he said that inflation drivers were becoming “much more conventional”. Unlike inflation brought about by a devaluation of the pound, higher wages are a much healthier sign for the economy. As inflation becomes “conventional”, the Bank of England is likely to respond using more conventional means as well. This means that more interest rate hikes are likely this year. Pound speculators continue to discount the probability of more rate hikes in 2018, and we believe this is misguided. Based on Carney’s testimony, the case for tighter monetary policy is much clearer.

Print Friendly, PDF & Email