Are there any positives for the pound ahead of the Bank of England meeting?

The pound held up surprisingly well against the dollar throughout January but now traders are positioning themselves for a few slightly weaker trading sessions ahead of the Bank of England policy meeting next Thursday.

The burst of activity favouring the pound came not so much from sterling’s strength as from expectations that the Federal Reserve will soon slow down its rate hikes after the US economy started showing signs of improvement. The last US GDP reading of 2.9% for the fourth quarter surprised on the upside and was comfortably above the 2.6% increase expected by analysts. A slowdown in US rate hikes will funnel investments away from currencies and into the bond markets, keeping the pressure on the dollar.

The Bank of England is widely expected to raise the rate by 50 basis points next Thursday and potentially another 25 basis points in March before pausing the current rate hike cycle. Although inflation is still running high at above 10% traders are pricing in a peak rate of 4.5% this year because the recent hikes have already started dampening economic growth.

The UK’s composite PMI for January dropped further into negative territory, coming in at 47.8 from 49.0 previously, (a number below 50 indicates shrinking rather than growth). This is the lowest composite PMI reading in two years and came as a slight surprise because analysts had expected the manufacturing and services to have held up better than that post-Christmas.

Longer term outlook

While the pound perked up against the dollar over the last month (less so against the euro), the underlying numbers will continue to weigh on the currency in the mid-term. One of them is the current budget deficit, which in December came in at £27 billion, the highest number since at least 1993 (when the current series of budget deficit data started).

More importantly, the December deficit was far higher than the £17 billion expected by analysts, courtesy of energy subsidies and other political decisions including Liz Truss’ budget. Public sector strikes are set to continue into February (a mega strike day of 100,000 public sector workers is scheduled for 1 February), with no sign of any consensus on the horizon. The eventual resolution will come either with a hefty price tag or will end up destabilising the current government, none of which bodes well for sterling.

There are some glimmers of light. UK GDP for November showed some growth which could mean that the economy might manage to avoid recession, even by a narrow margin. Despite falling output volumes and weak demand, optimism regarding the year-ahead outlook for business activity picked up in January and was the strongest since May 2022.

Also, with China re-emerging from months of strict Covid-induced lockdowns the country’s economy looks set to pick up some growth and help drive a turnaround in global economic conditions, and a slowdown in cost pressures, over the course of 2023.

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