- GBP faces a sizeable sell-off in November

- Following a Bank of England rate hike

- Wells Fargo sees downside to GBP forecast

- But HSBC says there is more to GBP than the Bank of England

Image © Bank of England

Market Rates at Publication:

GBP/USD: 1.3812

GBP/EUR: 1.1855

A veteran foreign exchange trader has warned that a "turbo charged" sell off in the British Pound could follow a widely anticipate November interest rate rise at the Bank of England.

Brent Donnelly, a former HSBC trader and now CEO of Spectra Markets, says the Pound is currently subject to "an incredible push and pull" involving UK interest rate futures markets.

Short-dated rates have made "an epic move higher" as markets rapidly price in the prospect of November interest rate rise: the move took off in the wake of unamibuous comments from Bank of England Governor Bailey that interest rate rises would be required to tame inflation.

Money market rates refer to the yield offered to investors for holding complex financial products; the important point to note for the purposes of this article is that they can tell us what investors are expecting from central banks.

What they are now telling us is that a November rate rise at the Bank of England is fully priced into market expectations, as are subsequent moves next year.

This is typically supportive of a currency and helps explain the recent rise in value of Sterling: the Pound to Euro exchange rate has reached new 20-month highs this week at 1.1872 while the Pound to Dollar exchange rate has reached one-month highs at 1.3822.

However, Donnelly notes a few peculiarities involving Sterling and current rate hike expectations as per money market pricing.

"It's unclear whether this is good for the currency. On one hand, higher nominals attract money. On the other hand, tightening policy into an energy shock just as fiscal stimulus peaks is bad," says Donnelly in a regular daily briefing.

Above: Short-term rates markets show a rapid surge in expectations for higher Bank of England interest rates.

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"To me, this looks like a sequencing thing where the models and some specs buy GBP as nominals rise in anticipation of the first hike, then once the hike happens, GBP gets wrecked," he says.

Donnelly observes it is common for a currency to rally into the first rate hike and sell off after.

"And I think this will be a turbo version of that," he says of the Pound. "Generally, it’s a buy the rumour / sell the fact thing."

But in the case of the Pound and a November rate rise at the Bank of England, the dynamic is said to be a little different than normal.

He says in situations where many speculators want to take a position, but there is a big event coming up, positioning is muted due to the volatility and jump risk.

Once the event is done, Donnelly says speculators are more willing to put on the trade, regardless of the outcome of the event.

"So they wait for the event to pass, then they sell," he says. "I think this is one of those."

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Furthermore, Donnelly notes that market expectations for a frantic pace of rate rises in 2020 are off the mark.

Indeed, money market pricing shows the Bank Rate could be at 1.0% by the end of 2022, which is unlikely given the Bank will have at this point started altering its quantitative balance sheet.

As such, "there is a good chance the Bank of England meeting sounds dovish as the hikes are characterized as “front-loaded” or “insurance”. That’s not super currency positive. And the entry point here is not bad!" Says Donnelly.

Pound Sterling Live's editorial team finds a significant majority of foreign exchange market professionals are highly skeptical of the Pound's recent gains and the ability of the Bank of England to deliver rate rises.

We have noted these views in a number of recent publications.

Nick Bennenbroek, International Economist at Wells Fargo says following the initial November hike, he expects another 25 bps increase in May 2022 and a further 25 bps in November 2022, meaning he sees the Bank of England's policy rate ending next year at 0.75%.

But this is a bit less than currently priced into interest rate markets.

"As a result the pound could face some downside for now, and there may also be some mild downside risk to our forecast of GBP/USD appreciation over the medium-term," says Bennenbroek.

That said, strategists at HSBC say there is more to the Pound than the Bank of England story, which if correct suggests a post-November hike apocalypse for the currency can be avoided.

"GBP remains mostly insensitive to the continued hawkish drift in UK rate expectations," says Daragh Maher, Head of Research, Americas at HSBC.

"For example, while the spread between UK and US rate expectations for a year’s time has widened by close to 50bp in favour of GBP since the start of September, GBP/USD has largely tracked sideways," he says.

Some analysts suggest this inability to track rates suggests the Pound is behaving in similar fashion to an Emerging Market currency.

Other analysts take the more benign view that it simply means a calming in inflation towards the end of 2022 means there is no pressure to really push rates higher on a longer term basis.

Whatever the case, "there is clearly more to GBP than some mechanical fixation on the BoE," says Maher.

The Pound's tendency to rise against the Euro and Dollar during spells of positive investor sentiment remains a key ingredient to its performance.

Global markets struggled in September as they faced a mix of concerns related to slowing global economic growth, production and energy woes in China, rising Delta cases and the prospect of higher interest rates at the Federal Reserve in the future.

The concerns triggered a decline in global stocks and the Pound followed alongside.

But October has seen these concerns digested by investors and steady buying interest has returned to the market, aiding Sterling gains.