Political Risks Rising Ahead of BOE Policy Update

The pound has exhibited notable strength in recent trading sessions, showcasing resilience against major currencies such as the euro and US dollar. This robust performance has translated into a renewed upward momentum for cable, pushing it back towards the 1.2600-level, while concurrently causing the EUR/GBP pair to dip below 0.8600. The underlying factors contributing to the pound's relative strength can be partially attributed to prevailing expectations that the Bank of England (BoE) will adopt a more measured approach in reducing interest rates next year compared to its counterparts, namely the European Central Bank (ECB) and the Federal Reserve (Fed).

According to current projections, the BoE is anticipated to initiate rate cuts sometime between June and August next year, with an estimated cumulative reduction of around 82 basis points throughout the year. The central bank's success in resisting early rate cut expectations is further supported by the comparatively higher starting point for inflation in the UK and the limited evidence thus far of a slowdown in core and service inflation. This positioning has granted the BoE's pushback against rate cut expectations greater credibility among market participants.

During these economic considerations, yesterday/today's release of the latest UK labour market report has provided some relief for BoE policymakers. The report signals a slowdown in wage growth, although it remains at an elevated level. Weekly earnings excluding bonuses have decelerated to 7.3% on a 3-month year-on-year basis, moving further away from the recent peak of 7.9%. While this indicates a positive trajectory, it is not deemed sufficient to prompt a dovish policy shift at the upcoming Monetary Policy Committee (MPC) meeting.

Simultaneously, political uncertainty is intensifying in the UK in anticipation of the forthcoming general election next year. Prime Minister Sunak is currently facing a pivotal parliamentary vote on emergency legislation related to Rwanda. Reports suggest that as many as 40 Tory MPs may either abstain or vote against the legislation. Considering the opposition from Labour and other parties, a rebellion by just 28 Tories could lead to the legislation being defeated. If such an eventuality occurs, it would mark the first instance of a government failing to pass legislation at the first reading since 1986, potentially undermining confidence in Prime Minister Sunak.

These recent political developments are contributing to an elevated risk of an earlier election in the UK next year. However, it is important to note that immediate impacts on the pound are not anticipated today, as the currency markets may take time to fully factor in the evolving political landscape. Investors will closely monitor these dynamic factors as they continue to shape the outlook for the pound in the foreseeable future.

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