GBP strength has been gathering momentum allowing the pound to top the G10 performance table in the year to date. We attribute the move to three factors. At the start of the year relief that the EU and the UK had agreed a trade deal lent some support to the currency. More recently the reflation trade started to morph into the vaccine trade and, in view of the UK’s swift roll-out programme gilts yields rose a little more than their peers. This has lent additional support to the pound. The third part of the bull run can be explained by the more hawkish than expected take-away from the BoE at the start of February. In contrast to other G10 central banks that have pushed back against market optimism regarding the pace of the recovery, the rhetoric from the MPC was upbeat. This is particularly true of comments from Chief Economist Haldane who has likened the economy to a coiled spring. The result is that fears that the Bank rate could turn negative this year have been quashed and markets are looking to the potential of a higher Bank rate on a 2 year view.
There is speculation in the market that some of the interest in the pound this year has been drawn from pent-up demand. There is evidence that investment levels in the UK were lower than they would have been otherwise in recent years due to political uncertainty related to Brexit. That said, any relief on the Brexit trade agreement announcement should be tempered by the fact that the deal agreed was not comprehensive or an improvement on market expectations. The services sector is largely out in the cold and hopes for regulatory equivalence for the financial sector have been diminishing since the start of the year. Talks between the EU and the UK regarding the Memorandum of Understanding for the financial services sector are now expected only to bring an agreement that there will be an open dialogue when either sides makes regulatory decisions. In addition, issues related to red tape at the UK’s borders and problems connected with the Northern Ireland protocol have ensured that Brexit continues to cast shadows. In particular, the Northern Ireland issue has the potential to complicate UK politics and weigh on the pound in the coming months. This week the DUP launched a legal challenge against the protocol. Ulster Unionists are deeply opposed to the de-facto border in the Irish Sea implied by the protocol which resulted from the agreement to avoid a border across the island of Ireland when the UK exited to EU.
Another hurdle for GBP could be the Scottish elections in May. If the SNP performs well, as expected, the possibility of another Independence Referendum will rise. Even though the UK government is standing firm against issuing an Article 30 order to grant permission for a referendum, Scottish press are reporting on the possibility of an ‘illegal’ vote potentially this year. This could raise further questions about the state of the union in the UK.
While the UK economy will be opening up this year, the PM’s plan is more cautious than many had expected and this could also hinder the pace of the economic bounce back. Johnson this week indicated that restrictions may not be fully lifted until June 21. While the government is likely hoping to over-deliver on this forecast, as in other countries, the opening up of the economy will depend on the path of the virus. The prevalence of border restrictions is also likely to depend on the speed of vaccine roll-outs elsewhere. Even as it re-opens the labour market and supply chains are likely to be undermined by scarring. Last year economic activity in the UK dropped further than any other G7 nations and while this suggests that the growth potential is strong, various businesses have been lost while other will struggle to return to normal.
Bullish momentum in the pound has pushed EUR/GBP through our long held 0.87 medium-term target. The move may have further to run in the near-term. However, we see bumps in the road ahead and see scope for pullbacks in the spring before EUR/GBP settles in the 0.85 area later in the year.