GBP rallies following a soft start to JulyLooks to reboot H1 outperformanceBarclays now bullish on GBPEURGoldman Sachs retains constructive stanceNatWest Markets wary of negative impact of rising mortgage rates

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The British Pound found some life following a lacklustre start to July and foreign exchange strategists say this month could see the UK currency continue to benefit from the UK's elevated interest rates.

UK two-year bond yields are proving an attractive offer for yield-hungry international investors as they remain close to their highest level since 2008, as markets move to price in further interest rate rises at the Bank of England.

"The 2yr Gilt yield surging a huge 150bps in the last two months. It helps explain why the GBP was the top-performing G10 currency in the first half of the year," says Derek Halpenny, Head of Research for Global Markets EMEA at MUFG Ltd.

The Pound was the best-performing major currency of the first half of 2023 as it advanced in value against the entire G10 field amidst a better-than-expected UK economic performance and rising interest rates at the Bank of England.

"We think GBP should outperform as real rates need to move higher," says Michael Cahill, foreign exchange analyst at Goldman Sachs.

The Pound to Euro exchange rate peaked at a 14-month high at 1.1738 towards the middle of June and the Pound to Dollar exchange rate peaked at 1.2848. However, both pairs have since eased back suggesting the rally has entered a phase of consolidation at the start of the new month and fiscal quarter.

But a weekly currency research report from strategists at Barclays maintains a positive stance on the Pound's outlook as elevated UK interest rates are anticipated to underpin global investor demand for UK assets.

"We have turned more positive on the pound in the near term," says Barclays, adding they have turned more positive on the Pound to Euro exchange rate in particular.

Driving the constructive sentiment on Pound Sterling are elevated expectations for the Bank of England's Bank Rate to peak near 6.0% have prompted a rise in UK bond yields, which in turn attracts investment capital inflows.

Research from Deutsche Bank reveals an unexpectedly large surge in demand for bonds from domestic retail investors as the Great British public "steps up" to fund an indebted government. International investors are also coming forward, favouring UK bonds over those where rates are lower in what is known as a 'carry' trade, which has the effect of underscoring demand for the Pound.

Above: GBPEUR at 15-minute intervals.

Sticky inflation and more proactive tightening are to maintain 'carry' support for the Pound, says Barclays.

The first half of 2023 has coincided with a shift in stance at the Bank of England from cautious to more assertive in light of persistently stubborn inflation.

"The recent 50bp surprise hike by the MPC points to a (long overdue) more proactive stance against inflation," says Barclays.

But analysis from NatWest Markets suggests some caution as the Pound will only likely be supported in this high-interest rate environment provided growth remains robust. A high-interest rate but low-growth environment would therefore be unsupportive of the currency's valuation, which analysts at the bank are wary of in H2.

"Sterling is expected to maintain a large yield premium over the EUR for the next 3 years and have an ever-increasing premium over the USD. The extent to which this supports Sterling will depend on the collateral damage it causes on the UK economy," says Paul Robson, Head of G10 FX Strategy for EMEA at NatWest Markets.

Above: GBP performance against G10 peers on July 04.

NatWest Markets recently recommended a short position on the Pound, eyeing its vulnerabilities in light of an expected economic slowdown linked to rising mortgage rates that are anticipated to weigh on consumer health.

But strategists at Barclays meanwhile find that the UK's inflationary problem is underscored by an economy still characterised by excess demand.

"Although further tightening could ultimately weigh on growth, the UK's inflation problem is a symptom of resilient demand amid tight labour markets and reduced aggregate supply, in our view. Resilient sentiment surveys support this interpretation," says Barclays.

Surveys out in June revealed consumer confidence continued to improve with GfK's much-watched reading showing an improvement for a fifth consecutive month. Lloyds Bank's Business Barometer meanwhile revealed business confidence rose to a 14-month high in June.

"As such, higher rates will likely enhance sterling's already considerable carry advantage, even as the bar for further hawkish surprises relative to market pricing remains high. Final PMIs stand out on the data docket this week."