All eyes on GBP and BoE

GBP: How long will the GBP continue to outperform?

It has been a positive week for GBP, as it reached new highs for the year against USD, EUR, and JPY. This continues the GBP's upward trend that began in early March. Among the G10 currencies, the GBP has been the top performer, strengthening by 8% against the USD, 4% against the EUR, and 11% against the JPY since March 8th. The GBP's bullish momentum is driven by expectations of a more extended tightening cycle by the Bank of England (BoE). Apart from a brief dip in mid-March due to the US regional banking crisis, UK yields have significantly increased during this period of GBP outperformance. The yield on the 2-year UK Gilt has risen by approximately 1.10 percentage points since March 8th, reaching a new cycle high of 4.97% yesterday. Notably, this rise in UK yields contrasts with the decline in yields in other major economies. In comparison, the 2-year US Treasury bond yield has fallen by about 0.50 percentage points, the 2-year euro-zone government bond yield has fallen by around 0.20 percentage points, and the 2-year Japanese Government Bond (JGB) yield has fallen by approximately 0.03 percentage points. Consequently, yield differentials have favoured a stronger GBP in the FX market.

The upcoming week will test market expectations for more aggressive BoE rate hikes through the release of the latest UK CPI report for May on Wednesday and the Monetary Policy Committee (MPC) meeting on Thursday. Given the recent repricing of market expectations, it will be more challenging for the BoE to surprise with another hawkish stance that would lead to further rate increases and strengthen the GBP. Fulfilling market expectations for an additional 125-150 basis points (bps) of hikes will be difficult. It would likely require the BoE to either revert to a larger 50 bps rate hike or provide a hawkish signal that a 50-bps hike is a realistic possibility at the next MPC meeting in August, where policymakers will have a better assessment of the inflation outlook with the updated Monetary Policy Report.

Despite concerns over higher inflation and the robustness of the UK economy, stronger wage growth should support the case for a hawkish policy update from the BoE. However, if the BoE only raises rates by 25 bps without signalling serious consideration of larger 50 bps hikes, it could trigger a temporary correction in UK yields and a modest decline in the GBP's value. Nevertheless, such an occurrence is unlikely to reverse the overall strengthening trend of the GBP. The most significant downside risks for the GBP would emerge if core inflation in the CPI report falls more than expected, and if the BoE strongly pushes back against the number of rate hikes currently priced into the UK rate curve. Although these risks are considered low probability for the upcoming week, their materialization could have a substantial negative impact on GBP performance.

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