The pound has had a barnstorming January — it’s on track to be the U.K. currency’s best month against the dollar since May 2009. And while part of the credit goes to a pullback in the greenback, traders shouldn’t discount other factors, analysts say: Brexit optimism, a resilient U.K. economy and the hawkish tone of the Bank of England.
On the last trading day of January, sterling
was up 5.1% on the month. It’s now trading at $1.4189 and inching closer to around $1.50, the level it was at before the Brexit referendum knocked the stuffing out of the currency. At the same time, the dollar
is poised to fall 3.4%, for its biggest monthly loss in almost two years.
“The continued slide in the dollar is undoubtedly playing a key role in this, but we can’t underestimate the impact that an agreement on phase one of Brexit talks has had,” said Craig Erlam, senior market analyst at Oanda.
“While there’s still a long way to go and arguably, the most difficult talks lie ahead, the agreement showed a desire on both sides to make this work. This was a major step forward,” he added.
After 11th hour negotiations, European Union leaders decided in December that the U.K. had made “sufficient progress” on three key divorce issues — EU citizens’ rights after Brexit, the Irish border and the exit bill — meaning the talks could move on to the highly important topic of trade. That phase one decision was seen as helping avert a so-called hard Brexit, in which the U.K. would crash out of the union without a trade deal.
That positive momentum for the pound was kept up in January, with the arrival of fresh economic data. These showed the U.K. as more resilient in the face of political uncertainty than most economists had expected: The economy grew 0.5% in the fourth quarter, beating the forecasts for 0.4%, while unemployment reached its lowest level since 1975.
That picture of health hasn’t been missed by the Bank of England, whose policy makers have been taking a hawkish tone. This week, BOE Governor Mark Carney said he sees signs of a pick up in U.K. wages — typically a key precondition for a rate hike.
In November, the U.K. central bank raised rates for the first time in a decade, aiming to rein in inflation. The inflation rate had spiked to 3%, due mainly to the plunge in the pound’s right after the June 2016 Brexit vote.
“If the market were to start believing in the risk of a second BOE rate hike this year, GBP could find further incentive,” said Jane Foley, senior FX strategist at Rabobank, in a note. “For this reason, we will be watching signs of domestically generated inflation closely in the coming months, in particular wage growth.”
What’s next for sterling?
Overall, analysts have mixed views about what’s next for the pound after the January rally.
Foley said it all comes down to how the Brexit talks between London and Brussels pan out, as recent reports suggest the two sides are poles apart in the trade talks.
On Wednesday, sterling tilted lower after a Reuters report that the EU has rejected the City of London’s proposal for financial institutions to retain passporting rights after Brexit. (Passporting eases local regulatory requirements to allow big banks, among others, to seamlessly operate across the single market.)
The report and the reaction raises questions about “whether the market was a little too hasty in building long GBP positions in recent weeks and whether these long positions have increased the vulnerability of the pound to bad news,” Foley said.
The next smoke signals for traders will likely come from the Brussels summit on March 22-23, where EU leaders are expected to discuss post-Brexit trade with the U.K. and a potential transition period.
All things considered, though, there is some scope for optimism around the negotiations, the Rabobank strategist suggests.
“Despite the difficulties that the trade talks will inevitably bring, it is our central view that the bones of a free-trade deal will be in place ahead of the March 2019 Brexit start date. On such an announcement, GBP is likely to surge,” she added.
And don’t forget that when the pound moves — whether a selloff or a rebound — it tends to do so in a dramatic fashion, notes Simon Derrick, chief currency strategist at BNY Mellon.
He pointed out that back in 1985, sterling slid to an all-time low of around $1.05, but then rebounded more than 30% within just four months.
It’s also worth noting that the average level for the pound-dollar pair over the last 20 years is a little above $1.60, he said in emailed comments: “Not saying that’s where it’s going, but it’s a useful point of reference.”