Commerzbank’s Michael Pfister highlights that the Pound has held up despite a weak UK real economy, persistent inflation and strained public finances, helped by reduced political risk and aggressive Bank of England (BoE) repricing from cuts to multiple hikes. He warns that tighter policy in a supply-driven inflation shock and fragile backdrop is ultimately negative for GBP, expecting higher EUR/GBP to extend in coming weeks.

BoE repricing turns into Sterling headwind

"Over the past few weeks, I have often wondered how much longer the pound can continue to weather the current market developments so well. After all, the real economy has been struggling for quite some time, inflation has not yet returned to pre-2022/23 levels, and public finances are under strain, as is the case in many other industrialised nations. In fact, the UK is arguably the country least able to afford the current oil price shock."

"The fact that the pound has nevertheless fared well over the past few weeks is likely due to two factors. First, political risks have been priced out following Labour’s loss of an otherwise safe constituency at the end of February. Secondly, there has been a reassessment of central bank expectations: instead of two interest rate cuts, more than three rate hikes are now expected by the end of the year."

"However, interest rate hikes are not necessarily positive in a context of strained public finances (the deficit is already widening due to higher interest costs) and a struggling real economy. While a central bank should respond to an inflation shock with a more hawkish monetary policy, should it do so immediately with three rate hikes in the case of a supply-driven rise?"

"For us, Friday’s higher EUR-GBP levels therefore came as no surprise. We see a greater likelihood that this trend could continue in the coming weeks."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)