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How strong will the pound sterling be in 2022?

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2021 began so promisingly for the pound.

Last Christmas Eve, the prime minister announced that a Brexit deal had finally been reached. The uncertainty which had plagued the sterling markets ever since referendum night in June 2016 appeared to be over. Presenting a deal that appeared to fulfil the majority of the secessionists’ main demands, while avoiding the worst nightmares of most “Remainers,” the pound seemed fully set for a major strengthening.

At the start of 2021, the UK also had a massive head-start in the global vaccination push. The UK was one of the first countries to authorise the AstraZeneca vaccine, whilst the European Union, for example, failed to negotiate a sensible deal with the pharmaceutical company – and then tried to sue it to distract from its own failures. President Macron of France even tried to undermine confidence in the UK’s vaccination programme by saying the vaccine was “quasi-ineffective” for certain groups, achieving only to drive down uptake of that very vaccine in his own country. There was a real sense in the markets that, not only was the UK outperforming major rivals, but that it was going to be the first major economy to free itself from the shackles of Covid. All of this created considerable upside momentum in the sterling markets.

This all seems so long ago now. In early London trading on Monday this week, the pound approached a one-year low against the US Dollar. 2022 could be a torrid year for GBP. We see five main reasons why:

Coronavirus Response

Firstly, there are growing concerns surrounding the omicron variant of coronavirus. Despite data from South Africa suggesting this variant is much milder than previous ones, the prime minister has decided to reimpose certain restrictions. This is despite the fact that over 120 million vaccinations have been offered, with uptake reaching almost 90%. The fact that the UK seems destined for a further tightening, contrary to the promises of politicians that a successful vaccination programme would end the need for any restrictive measures, is likely to weigh heavily on the pound. If growth and economic activity is again limited, as seems inevitable if any more restrictions are introduced, there could be scope for harsh moves in sterling markets.

Political Divisions

The political consequences of this new push for more restrictions could also weigh on the pound’s performance. Many Conservative Members of Parliament are bitterly opposed to the prospect of any new Covid restrictions – particularly the proposed introduction of vaccine passports. When the measures were put to the House of Commons yesterday, almost one hundred Tory MPs voted against the government. This means the government were forced to rely on the votes of opposition Labour MPs for the vote to pass, opening up divisions within the ruling party. As we saw during the tumultuous Brexit years, any sustained period of political uncertainty and manoeuvering can significantly affect how strongly the pound performs. Whilst we seem a distance away from any attempts to topple Johnson, GBP will not enjoy this new atmosphere in parliament – of a prime minister not entirely secure or at ease with his own party.

BOE Uncertainty

Then there is the issue of interest rates. Traders had been pretty confident that the December meeting of the Bank of England – due to take place this Thursday – would see a slight rise in rates. This is no longer the case. Whilst the ECB and Fed have been relatively open about their plans (even if the latter recently took a hawkish turn), the Bank of England has appeared reluctant to make firm indications on the stimulus issue either way. This means traders and analysts have been caught off-guard, and adds a further element of uncertainty to sterling markets. As Neil Jones, head of institutional FX Sales at Mizuho, told Bloomberg:

“Up until recently we had a December hike and a zero-lockdown scenario as bolted on for the U.K.  This week has seen an abrupt 180 on the rate- and Covid-trade as far as the pound is concerned.”

The fact that traders cannot accurately predict movements in interest rates could influence pricing within GBP markets, and could mean that prices move more sharply in response to any hikes or reductions in rates.

Ultra-Low Rates

But it’s not just that traders can no longer forecast with any confidence what the Bank of England might do. The maintenance of ultra-low rates in the UK would also be further bad news for the pound. Within reason, higher interest rates are good news for a currency’s performance on foreign exchange markets. This is because higher interest rates mean investors achieve increased yield by holding that currency. With other major central banks – including the Federal Reserve – going in a more hawkish direction (in response to higher inflation) the pound could end up significantly less attractive than other G7 peers. Why would you hold the pound when you can achieve better yields by holding the US dollar, which is also considered a safer currency to own anyway?

Inflation

Finally, the threat of high rates of inflation could weigh on the pound throughout 2022. Inflation is now at its highest level in a decade and remains significantly above the BOE’s target of 2%. High inflation increases the price of exports relative to other currencies, making the country less competitive and reducing demand for that currency. For this reason, rampant inflation puts downward pressure on a currency’s value on foreign exchange markets. The usual response to increased levels of inflation is to rise interest rates. But the Bank of England seems intent on maintaining ultra-loose monetary conditions for as long as possible, probably because they view cheap money as key to keeping businesses going through the pandemic. It is therefore not inconceivable that 2022 could see the nightmare scenario for the pound in which inflation continues to rise but interest rates remain rock-bottom.

Of course, only time will tell how well the pound will perform in 2022. But what is for sure, is that the optimism with which we started the year appears to have vanished.

Author: Harry Clynch

#PoundSterling #GBP #ForeignExchange #Vaccinations #EuropeanUnion #Covid19 #USDollar #USD #OmicronVariant #InterestRates #ECB #FederalReserve #Inflation

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