We reflect on a mixed month for sterling and why central banks have taken a hawkish turn.
Mixed month for sterling
June proved to be a relatively volatile month for the pound. The currency traded with more than a 3.0% range versus the US dollar, weakening, at one point, by as much as 2% against the greenback, before recovering to end the month more than 1% higher.
Sterling weakened early in the month on the back of the UK general election result, as the Conservatives’ failure to increase their majority was seen as weakening the government’s negotiating position with Brussels over the terms of the country’s exit from the European Union. There were expectations that the increased uncertainty surrounding Brexit might put the Bank of England off of tightening monetary policy any time soon, however, recent comments from members of the Monetary Policy Committee have suggested that raising interest rates before the end of the year is a real possibility, sparking a rally in the pound.
What to take away from it?
Going forward the direction of sterling is likely to be largely dependent upon the progress of Brexit negotiations and the strength of UK economic data. Progress towards a deal with the European Union, particularly one that would be considered a ‘soft’ Brexit, would likely be supportive of the pound, whilst failure to reach a deal, or a deal that is overly onerous on the British economy, could bring about renewed weakness in the currency. Although recent comments from Bank of England members have struck a more hawkish tone, Governor Mark Carney made it clear that while it might be necessary to raise interest rates reasonably soon, this would depend on how the economy performs, in particular whether the current above-target inflation is sustained, whether wage growth is able to accelerate, and whether business investment is able to take up any of the slack from a slowdown in consumer spending.
Central banks take a hawkish turn
It wasn’t just the Bank of England that took a hawkish turn during June. Since the financial crisis, the world’s major central banks have often pursued similar policies and recently we have seen each of the Bank of England, the US Federal Reserve and the European Central Bank move towards less accommodative monetary policies. The Fed has been the frontrunner with three interest rate hikes in the last eighteen months, however, the Bank of England’s Chief Economist, who voted for rates to remain unchanged in June, said that he could change his mind “relatively soon”, while ECB Chief Mario Draghi recently spoke positively on the eurozone economy and remarked that the threat of deflation had now been replaced with “reflationary forces”.
The shifting stance at the Bank of England, Fed and ECB has coincided with improving economic data and also doubts over the continued efficacy of ultra-accommodative monetary policies. Inflation, which in recent years was at, close to, or sometimes below zero in a number of economies, has recovered to the extent that it is now above the Bank of England’s target in the UK, and closer to the Fed’s and ECB’s targets in the US and euro area economies, respectively. Furthermore, Donald Trump’s election in the US and the recent result of the UK General Election are perhaps suggestions that the age of austerity has come to an end and that more aggressive fiscal policies can be expected going forward, something which might contribute toward inflationary pressures.
What to take away from it?
Core government bonds weakened in June in response to this apparent concerted shift in central bank policy. Two-year yields on US, UK and German government debt were higher by 23, 14 and 10bps respectively, while ten-year bond yields were also sharply higher. If central banks are to continue or begin to tighten monetary policy then it is likely that short-dated government bond yields will rise. However, central banks have less control over the longer end of the yield curve, with bonds with longer maturities more sensitive to expectations of inflation and economic growth. For longer-dated bond yields to rise, market participants would need to be confident of the growth and inflation prospects of each economy. A scenario where short-dated bond yields are rising due to tighter central bank policy, but long-dated yields are either falling or rising less than those at the shorter end of the curve (the yield curve is flattening), could be an indication that the market is unconvinced about further growth and inflation and is expecting central banks to eventually reverse course and return to loosening monetary policy.