London– GBP Britain's economy has jumped to its highest level in two-and-a-half years after the Bank of England maintained hawkish interest rates, but strategists warned that the upcoming UK budget could pose risks to investor and consumer sentiment.
Many investors are awaiting the new Labor government's fiscal plans at the end of October before making longer-term forecasts for the UK economy and assets, with Prime Minister Keir Starmer warning that future decisions will be “painful” for the public.
Meanwhile, Labor will convene its annual party conference on Monday, the first in its 15 years in power, as its leadership attempts to top the latest Donation dispute and Promise to “rebuild Britain”.
After the Federal Reserve cut interest rates last week, the Bank of England kept interest rates unchanged. Both actions were expected, but the former's tone was unexpectedly tough, emphasizing the need for “gradual” easing, while the latter chose to cut interest rates sharply by 50 basis points, emphasizing the need to support the U.S. labor market.
On Thursday, GBP/USD traded above $1.33 for the first time since March 2022, trading at $1.3315 in early London time on Monday.
GBP/USD exchange rate.
Chris Turner, ING's global head of markets, said in a note on Friday that the pound's gains were linked to communications from the Bank of England that “looked entirely reasonable”. Traditionally, higher interest rates are good for domestic currencies because higher yields attract more foreign capital.
“The Bank of England does seem to be questioning whether inflation will fall as it has elsewhere in the world… (the Bank of England) does not appear to be in the camp of the Fed issuing an 'all clear' signal on inflation,” Turner said.
The Bank of England's main concerns remain services sector inflation (which rose to 5.6% from 5.2% in August) and wage growth (which also remained above 5% annually).
The pound's gains last week built on long-term trends, with analysts broadly betting that a landslide Labor victory in July's election would be good for Britain's prospects, citing reasons including increased political stability, plans to reform housing policy and strengthening ties with the European Union. and other factors.
But some have warned that the pound's recent gains on interest rate differentials could be hurt by the budget due to be announced on October 30.
Jane Foley, head of FX strategy at Rabobank in London, told CNBC via email that the fiscal plan could become a test for sterling bulls if the tax increase weakens the temporary improvement in British investor confidence.
Increases in VAT, national insurance (a general tax) and income tax have all been ruled out, but other tax rises, a crackdown on the super-rich and public spending cuts may be coming.
The Labor Party has repeatedly emphasized that boosting Britain's sluggish economic growth is its top priority.
On Friday, UK retail sales rose 1% in August, helping to support the pound, “but leading indicators of consumer confidence warned that consumers are starting to become fearful,” Turner said.
This in turn could have an impact on consumer spending and short-term growth.
Gabriella Dickens, G7 economist at AXA Investment Managers, also warned about the pound's prospects in a report on Thursday.
She said a 25 basis point rate cut in November would be consistent with the Bank of England continuing to take “gradual” action, but beyond that, the main risk remained the budget.
“If fiscal policy becomes tighter than the previous government currently mandated, this could increase pressure on the central bank to accelerate the rate-cutting cycle,” Dickens said.
“Given recent signals from the new government, including references to a £22bn black hole in the public finances and hints of possible further tax increases, this seems likely to us. If the government is more stringent on fiscal policy, we think Central banks will be forced to accelerate the pace of their rate-cutting cycles to offset the hit to household and business finances.
Prospects mixed
ING strategists do expect the Bank of England to become more confident about the UK's inflation trajectory later this year and could accelerate rate cuts after markets have priced in a November rate cut.
“However, this may take some time and in the meantime the pound can continue to perform well,” which could push the pound to the $1.35 area, Turner said.
while Bank of England Governor Andrew Bailey Denied Huw van Steenis, deputy chairman of Oliver Wyman, told CNBC's “Squawk Box Europe” on Friday that with public sector pay rises a key driver of inflation, policymakers will be watching closely to see whether Labor gives a “significant” salary increase.
Britain's new Labor government will offer above-inflation pay rises to millions of public sector workers, including teachers and doctors.
“One thing coming from the Bank of England is that they want to keep costs the same next year, but they are a little nervous that they are going to have to give more of a boost,” he said.
He added: “If you read the Bank of England statement, it's clear that they are digging deep and they want to emphasize incrementalism in bold.”