Consideration #1: A Hawkish Bank of England
The morning of Thursday, August 4, the Bank of England (BoE), the United Kingdom’s central bank, enacted a substantial interest rate hike: 50 basis points (bp), bringing the base rate up to 1.75%. The size of this hike is the BoE's largest since 1995, which had last occurred before it had even gained its current institutional independence from the British government. This hawkish development is timely, considering annual inflation in the UK is currently at 9.4%, the highest rate since 1982.
Consideration #2: Context is Key
However, this increased comfort with contractionary monetary policy from the BoE can also reasonably be interpreted as too little, too late. With the highest rate of inflation in the G7, it would be fitting for the BoE to likewise lead by example when it comes to tightening measures. Rather, their first 50 bp rate hike follows the Federal Reserve’s 75 bp hikes, and the Bank of Canada’s full 100 bp rate hike, not even exceeding market forecasts. This hike seems more akin to treading water than rising to the occasion, reminding us that historic doesn’t necessarily mean adequate.
My GBP Bias: Bearish
Despite the BoE’s historically hawkish move, this does not appear to signal a meaningful newfound commitment to subduing high inflation. Thus, I personally do not interpret the narrative surrounding GBP fundamentals to have changed, at least in any significant sense. Considering the lukewarm rate hikes, persistence of high inflation, and the plausibility of eventual stagflation in the UK, I will be looking for opportunities to short GBP against stronger currencies.
Best Pairs to Trade
According to the EdgeFinder, an A1 Trading tool for supplemental analysis, here are two of the most potentially promising pairs to trade for GBP bears: 1) GBP/USD, which earns a -4 ‘sell’ signal, and 2) GBP/JPY, which earns a -3 ‘sell’ signal.
GBPUSD reached a new two-year low today upon falling beneath 1.19 support yet again, the second time since last week. These lows are due in part to USD strength after Friday’s strong Non-Farm Payroll data revealed over 100,000 more new US jobs than were expected; as traders anxiously await Wednesday’s new CPI numbers, anticipation for red-hot US inflation grows. However, much of GBPUSD’s bearish momentum is due to the Pound itself, and unusual, pessimistic circumstances that the UK’s economy is facing. Let’s explore what these conditions are as we issue a warning: how doomed is GBP?
1) Resignations & Other Chaos
On July 7th, a Thursday morning, UK Prime Minister Boris Johnson resigned as leader of the Conservative Party. His stepping down came amid an unexpected mass resignation of over fifty Conservative members of parliament (MPs), due to disappointment in party leadership over a slew of scandals. It is worth noting that while Johnson has resigned as head of his party, he intends to remain Prime Minister over the next few months, until the governing Conservative Party elects a new leader to replace him. These events have aided in throwing Parliament into disarray, and will certainly not improve its economic problem-solving efficacy, nor any sentiment adjacent to it.
While political resignations of this magnitude would be inconvenient for any country to experience, this is especially difficult for the UK, since post-Brexit trade deals are still either in their infancy or have yet to be negotiated. Since 2020, when Brexit took effect and the UK’s trade to GDP ratio declined by 8.31% (from 63.4% to 55.09%), trade statistics have been volatile and tricky to analyze, especially in light of post-COVID supply chain issues. According to the UK’s Office for National Statistics, “It continues to be difficult to assess the extent to which trade movements reflect short-term trade disruption or longer-term supply chain adjustments.”
2) A Reluctant Bank of England
The UK’s annual inflation rate hit a staggering 9.1% in May, the highest among the G7 countries. In theory this should be bullish for GBP, because higher inflation implies a growing economy and serves as an antecedent to rate hikes, which are central bank attempts to stabilize prices. However, despite the Bank of England (BoE), the UK’s central bank, warning that annual inflation could reach 11% in the coming months, they lag significantly behind the US’ Federal Reserve in terms of hawkish aggression. They have thus far only resorted to 25 basis point rate hikes within the past year, with their target interest rate currently at 1.25%; this slow pace is nearly as tepid as tightening monetary policy can be. This hesitancy to stamp out UK hyperinflation is extremely bearish for GBP.
3) A Rising Unemployment Rate
The UK’s unemployment rate recently ticked up to 3.8%. While rising unemployment is a bad sign for the performance of any country’s economy, this is particularly problematic for the UK and the Bank of England for two reasons. First, considering that the BoE’s target interest rate is a relatively low 1.25% while inflation is at 40-year highs, for unemployment to already be increasing is discouraging. This indicates fragility in the UK’s labor market, and by extension their economy, which likely contributes to the BoE being wary of contractionary monetary policy. Second, if the UK labor market continues to be acutely sensitive to a cooling economy, this joblessness might especially aid in slowing consumer spending, reducing the overall need for BoE intervention via rate hikes (unless stagflation surfaces).
4) Bearish Institutional Sentiment
According to recent Commitments of Traders (COT) data, GBP clocks in as the third most shorted COT asset, with 70.75% of all institutional traders selling the Pound. This bearishness is a significant factor in creating GBP selling pressure, since much of forex price action is generated by institutional activity, due to the sheer scale of their purchases and sales.
What Happens Next?
For now, fundamentals for GBP appear rather bleak despite high inflation, and COT data reflects this. However, there is a chance that this hyperinflation in the UK could eventually force the BoE’s hand, prompting them to eventually lean into hawkishness to prevent catastrophic overheating. While this pivot could be around the corner, along with newfound GBP bullish momentum, traders would be wise to not assume this is the case until there are clear signs from the BoE. Unless this happens, GBP seems primed for continued selling.
Best Pairs to Trade
While GBPUSD has received a ‘strong sell’ signal from the EdgeFinder, an A1 Trading tool for supplemental trading analysis, there are many other GBP pairs potentially worth trading too. Such pairs include GBPCAD, which likewise receives a ‘strong sell’ signal, as well as GBPAUD and GBPNZD, which both receive ‘sell’ signals. Along with GBPUSD, these four pairs all rank in the EdgeFinder’s top eight pairs worth selling.