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Pound Sterling Fights to Hold a Weekly Gain against Euro and Dollar

- GBP sunk by BoE's signal on -ve interest rates
- von der Leyen comments spark a sudden jump
- But negative rates at BoE not a done deal say economists
- GBP selloff overdone says TD Securities

von der Leyen

Above: Ursula von der Leyen. Photographer: Etienne Ansotte. European Union, 2020. Source: EC - Audiovisual Service

  • GBP/EUR spot: 1.0933 | GBP/USD spot: 1.2963
  • GBP/EUR bank rates: 1.0727 | GBP/USD bank rates: 1.2700
  • GBP/EUR specialist rates: 1.0835 | GBP/USD specialist rates: 1.2856
  • Learn more about market beating exchange rates, here

The British Pound is on course to record a weekly gain against the Euro, U.S. Dollar, Australian Dollar and a host of other major currencies after the EU Commission President offered supportive words on Thursday that unwound the deep losses triggered by the Bank of England.

It has been a tumultuous 24 hours for Sterling, falling on the Bank of England news but then suddenly recovering on comments made by EU Commission President Ursula von der Leyen who said she remains "convinced" an EU-UK trade deal is still possible.

The Pound shot higher and recorded its best levels of the day following the comments made in a Financial Times interview: "I am still convinced it can be done,” Ms von der Leyen said in an interview. "It is better not to have this distraction questioning an existing international agreement that we have, but to focus on getting this deal done, this agreement done - and time is short."

One EU diplomat added that "we should not overreact... We will continue negotiations because there are two separate tracks: one is the one which the UK has decided to violate, and the other is the future relationship."

The past two weeks have seen tensions between the EU and UK heightened over the UK's attempt to reverse some aspects of the EU-UK Withdrawal Agreement struck last year after it published domestic legislation that would override elements of the Withdrawal Agreement's Northern Ireland Protocol.

Although the EU is said to be considering legal sanctions against the UK over the matter, negotiations continue.

Expect to see Sterling supported around current levels should the market maintain a view that a trade deal is still possible despite the flexing of muscles by both sides over the past two weeks.

The Pound-to-Euro exchange rate is holding a 1.22% advance for the week and is quoted at 1.0937 at the time of writing, the Pound-to-Dollar exchange rate is quoted at 1.2954 having advanced 1.23% this week. The Pound-Australian Dollar exchange rate is up 0.80% and is quoted at 1.7714.

GBP volatility

"The pound remains volatile, falling yesterday after the Bank of England policy minutes noted that the MPC had been briefed on how negative interest rates could be deployed effectively. It later pared some losses on hopes of a UK-EU trade agreement, especially after European Commission President Von der Leyen said she is ‘convinced’ a deal is possible," says Hann-Ju Ho, Senior Economist, Commercial Banking at Lloyds Bank.

The Pound fell sharply on Thursday after the Bank of England said it had stepped up its work in establishing whether it was possible to cut interest rates to 0% or below over coming months, if the economy required.

Sterling exchange rates did not appreciate the unexpected news as negative interest rates have never before been seen in the UK and could destabilise the financial system, particularly because no other country that has introduced negative interest rates thus far have the same dynamics as the UK, namely a gaping current account deficit.

This leaves the UK's financial system, and Pound Sterling in particular, exposed to capital withdrawals from foreign investors. "Cutting rates to below zero in the wake of a decision to leave the EU without a trade deal, would indeed seem reckless," says Kit Juckes, Global Head of FX Strategy at Société Générale. "Denmark, the Eurozone, Switzerland, Sweden and Japan all have negative rates, but they all have sizeable current account surpluses."

"The UK needs to attract foreign investors, not push them away," adds Juckes.

The Bank of England released a relatively benign statement following its September deliberations, however the minutes to the meeting contained something of a bombshell for foreign exchange markets when the Bank said it would start a "structured engagement" with the Prudential Regulation Authority on issues concerning the potential for cutting interest rates to negative.

Negative interest rates are something of a lightning rod for currencies and Sterling fell against its peers, with investors interpreting the statement to be the Bank conditioning the market for negative interest rates being introduced in 2021.

UK money markets are now pricing in a 60% chance of a 0.25% cut in the Bank's basic interest rate which would take it to -0.15% by this time next year.

GBP/EUR fell to a daily low of 1.0903 in response to the developments, having been as high as 1.10 earlier, the GBP/USD exchange rate fell from a high of 1.2952 to record a daily low of 1.2866 while the GBP/AUD exchange rate fell to a daily low of 1.7622 having been as high as 1.7837.

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"The U.K. Pound staged a swoon after the Bank of England dropped clear signals that it was edging closer to implementing negative borrowing rates," says Joe Manimbo, Senior Market Analyst at Western Union. "The big news was that officials were actively studying plans to push rates below zero given the “unusually uncertain” economic outlook. Central bankers noted better data of late but signalled heightened concern related to Covid uncertainty, expectations of a sharp rise in unemployment and potential Brexit shocks."

However not all economists are convinced the markets are right to sell the Pound, with some arguing that while the quantitative easing programme might be expanded negative interest rates are unlikely.

"GBPUSD traded lower after the BoE said it would discuss the “operational considerations” of negative policy rates. Significant follow-through selling pressure has yet to emerge, however, and we think the move so far looks overdone," says Jacqui Douglas, Chief European Macro Strategist at TD Securities.

"We think that the market reaction has been overblown, and that this is all part of the already well-known research that the BoE is conducting into negative rates. We would still lean against the idea of negative Bank Rate, particularly as soon as November, short of another full-blown national lockdown between now and then," adds Douglas.

The potential for negative interest rates first appeared on the Bank's radar following the coronavirus market meltdown of March when it cut the base rate twice, from 0.75% to 0.25% and then to 0.1%.

Negative interest rates are intended to encourage lending – and therefore business investment and consumer spending – by disincentivising banks for leaving excess cash with the central bank, however they do have potential unintended side effects. The Bank is not quite sure of what these might be of yet but they might include further detrimental declines in the value of Sterling and compromising the ability of commercial banks to function, which is why the matter is being studied.

 

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While the European Central Bank launched negative rates in 2014, cutting its deposit rate to -0.1pc, and the Bank of Japan introduced them in 2016, neither countries have the significant current account deficits the UK has, which would make comparisons with Japan and the Eurozone unhelpful.

"Sterling dropped by around a cent on this news, below $1.29. Our view is that although they are not the favoured instrument, the BoE has said that negative rates are part of the BoE’s toolkit. It would be ridiculous therefore if various parties (including commercial banks at some stage) did not engage in technical discussions soon," says Philip Shaw, an economist at Investec.

"Our baseline case remains that the MPC will avoid introducing negative interest rates," adds Shaw.

Despite Investec not expecting the Bank to cut interest rates to negative, they do see the Bank boosting its quantitative easing programme by the tune of £75BN in November.

Most economists are of the opinion the Bank will introduce further quantitative easing simply because the current tranche of £750BN will have run out by the time year-end arrives. With the economy set to be smaller than where it started the year, economists are of the opinion the Bank simply won't allow the programme to come to an end at this point and a new envelope will be issued.

"We think that it will loosen policy further, most likely in the form of more QE rather than negative interest rates as the market expects," says Andrew Wishart, UK Economist at Capital Economics.

Capital Economics are forecasting an extra £250BNn of quantitative easing to be introduced over the course of the next year, with an instalment of £100BN in November.

The Bank of England was relatively sanguine about the current state of the economy noting that a recovery is underway, however they are looking ahead somewhat and see a number of potential issues that could scupper the recovery, including the potential for unemployment to rise sharply into year-end, a pick up in covid-19 cases and the market's rising expectation for a 'no deal' outcome to Brexit trade negotiations.

Such clouds on the horizon suggest the Bank will need to lend its support to the economy again in coming months, but whether this support involves negative interest rates is not necessarily set in concrete.

Sterling could recover if the market believes interest rates are in fact not going to be delivered, however a lot will need to go right before this shift in mindset happens.

"Heading into today's decision, we were not looking for the MPC to provide GBP with a strong directional cue. We'll need to see how things hold, but our base case holds to that view. Once the initial headline impact fades, we think the FX market will soon turn its attention elsewhere," says Ned Rumpeltin, European Head of FX Strategy at TD Securities. "With support at 1.2877 containing the pullback in GBPUSD, at least so far, we are inclined to look for the pair to continue consolidating within familiar ranges over the very near term."


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