LONDON — The British pound has surged to a two-and-a-half-year high after the Bank of England kept interest rates on hold in a hawkish manner, but strategists are warning that Britain’s next budget could pose risks to investor and consumer sentiment.
Many investors are waiting for the new Labour government’s fiscal plans to be published at the end of October before making any longer-term forecasts for the UK economy and their wealth, with Chancellor Keir Starmer warning of “painful” decisions ahead that will cost Britain money.
Meanwhile, the Labour Party, in power for the first time in 15 years, holds its annual conference on Monday with party leaders aiming to move beyond the recent row over donations and pledge to “Rebuild Britain”.
The Bank of England left rates on hold last week when the Fed cut them. Both policies were expected, but the former took a surprisingly hawkish stance, emphasizing the need for “gradual” easing, while the latter stressed the need to support the US labor market and opted for a much larger 50 basis point cut.
The pound topped $1.33 against the US dollar for the first time since March 2022 on Thursday and was trading at $1.3315 early London time on Monday.
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Pound/dollar exchange rate.
The pound’s rise is linked to the Bank of England’s announcement and “appears entirely justified,” Chris Turner, head of global markets at ING, said in a note on Friday.Higher interest rates are traditionally positive for domestic currencies, with higher yields able to attract more foreign capital.
“The Bank of England seems to be seriously doubting whether inflation will fall to the same extent as other parts of the world. They don’t seem to be joining the Fed camp of sending a ‘no problem’ signal on inflation,” Turner said.
The main concerns for the BoE are services inflation, which rose to 5.6% from 5.2% in August, and wage growth, which is also above 5% on an annual basis.
Last week’s rise in the pound was based on a longer-term trend, and analysts say the outlook for Britain is broadly positive due to factors such as greater political stability following Labour’s landslide victory in July, housing reforms and closer ties with the European Union.
But some have warned that the pound’s recent strength, driven by interest rate differentials, could be put at risk by the Budget, due to be announced on October 30th.
“The fiscal plan could pose a test for sterling bulls if tax increases erode the tentative improvement in UK investor confidence,” Jane Foley, head of currency strategy at Rabobank London, told CNBC in an email.
Increases in VAT, national insurance and income tax have all been ruled out, but other tax hikes, a crackdown on the super-rich and cuts to public spending are possible down the line.
Labour has repeatedly stressed that its top priority is accelerating Britain’s sluggish economic growth.
A 1% rise in UK retail sales in August helped pound rise on Friday, “but leading indicators of consumer confidence are warning that consumers are starting to get nervous,” Turner said.
This could impact consumer spending and growth in the near term.
Gabriella Dickens, G7 economist at AXA Investment Managers, also warned about the pound’s outlook in a note on Thursday.
A 25 basis point cut in November would be consistent with the Bank of England continuing to pursue a “gradual” approach to policy, but beyond that the main risk remains the budget, she said.
“If fiscal policy is tightened more than the previous administration is currently planning, there will likely be increased pressure on the central bank to quicken the pace of the rate cutting cycle,” Dickens said.
“This is likely given recent signals from the new government, such as a £22 billion budget deficit and references to the possibility of further tax increases. We believe that a tighter fiscal policy from the government will force banks to quicken the pace of their rate cutting cycle to offset the hit to household and business finances.”
A complex outlook
ING strategists expect the Bank of England to become more confident about the UK’s inflation trajectory later this year, which could lead to faster rate cuts after the November cut that markets are pricing in.
“But that may take time. In the meantime, the pound could continue to perform well,” Turner said, adding that the pound could rise to around $1.35.
Bank of England Governor Andrew Bailey has denied that rising civil servant salaries are the main driver of inflation, but policymakers will be closely watching Labour’s “significant” pay rises, Oliver Wyman deputy chairman Hugh Van Steenis told CNBC’s “Squawk Box Europe” on Friday.
Millions of civil servants, including teachers and doctors, are set to receive an above-inflation pay rise from Britain’s new Labour government.
“There’s talk that UK banks were hoping to keep costs flat next year but are now getting a bit worried they might be forced to increase costs further,” he said.
He added: “If you read the (BoE’s) statement it’s clear they are adamantly resisting. They want to emphasise gradualism and put it in bold type.”
