GBP risks setback vs .EUR & USD in 2022BoE rate bets challenged by virus variantFurther restrictions & politics could weigh

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Pound Sterling was one of the better performing major currencies in the final week of trading ahead of the festive break but is at risk of a setback in the new year, according to some analysts, who say that economic risks could lead the market to doubt its assumptions about the Bank of England (BoE).

Sterling edged higher against all major currencies in the week to Thursday except those with a greater sensitivity to changes in investors’ risk appetite, such as the Canadian, Australian and New Zealand Dollars, while GBP/JPY posted the Pound’s largest gain.

The Pound to Euro exchange rate was closer to 1.18 than 1.17 while on course to end the year with a more-than six percent gain having been lifted through much of December by a series of UK economic figures that culminated in an interest rate rise from the BoE last week.

Bank of England policymakers voted to lift Bank Rate from 0.10% to 0.25% after inflation was seen topping five percent for November, more than twice the targeted rate, and after other data confirmed that ending HM Treasury’s furlough scheme did not lead to an increase in unemployment.

“In our view the market has still priced-in too many BoE rate hikes for 2022. We anticipate that these will be partly unwound in the coming months and that this could weigh further on the pound,” warns Jane Foley, head of FX strategy at Rabobank.

“We see EUR/GBP creeping up towards 0.87 [GBP/EUR to 1.15] during the course of next year,” Foley and colleagues said in a Monday research note.

Above: Pound to Euro rate shown at daily intervals alongside Pound to Dollar.

Reference rates at publication:

GBP to EUR: 1.1794 \ GBP to USD: 1.3367High street bank rates (indicative): 1.1564 \ 1.3093Payment specialist rates (indicative: 1.1735 \ 1.3300Find out more about specialist rates, hereSet up an exchange rate alert, hereLast week’s rate rise was unexpected in the market by the time that it came around while the accompanying remarks from the BoE prompted investors to wager more heavily and with increased confidence that the bank could be likely to lift Bank Rate at least three times in 2022.

The BoE’s Bank Rate was cut from 0.75% to a new low of 0.10% following the onset of the coronavirus crisis in early 2020 while December’s rate rise marked the first in a likely series of steps to begin reversing those cuts.

However, Rabobank’s Foley and others see the BoE’s process of monetary policy normalisation being at risk from the pandemic picture and domestic politics in the UK, with possible consequences for Sterling over the coming months.

“Although PM Johnson is holding off from announcing more stringent measures after his roll-out of ‘Plan B’ earlier in the month, many large organised events have been cancelled in the UK and the hospitality sector is suffering as people choose to stay away,” Rabobank’s Foley says.

“While there is no imminent general election in the UK, Johnson’s leadership is looking weak. This does nothing to strengthen confidence in post Brexit Britain and, on the margin, will undermine the pound,” Foley and colleagues also said.

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Foley and the Rabobank team cited the latest variant of coronavirus and the government’s response to it as immediate headwinds for the UK economy and Pound as it transitions into the new year, and also warned that political risks could also reenter the picture as 2022 gets underway.

“There may be a leadership challenge within the Tory party in 2022, but snap election risks are low. However, IndyRef2 issues could restrain GBP appreciation from H2 onwards,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

“That risk is reflected in our 12M GBPUSD view. Our 3M and 12M GBPUSD calls are 1.29 and 1.32, respectively,” Gallo and colleagues said in a December review of BMO’s forecasts.

The danger is that a combination of virus developments and political risk dampens momentum in the economy and clouds the outlook enough for investors to then question the market-implied assumption that BoE policymakers are likely to lift Bank Rate again in February.

That could potentially act as a constraint upon, if not weigh heavily on the Pound during the opening months of the new year.

Above: Pound to Euro rate shown at weekly intervals alongside Pound to Dollar.