GBP Confounds the Critics

Written on 29/12/2021 by Lukman Otunuga, Senior Research Analyst at FXTM

Many analysts were predicting impending doom for the UK’s currency with headwinds around the fast spread of Omicron especially troubling. There was much angst that the government would be forced to impose new restrictions as rising and record infection rates would lead to major issues for the national health service.

Potential political upheaval had also been brewing, as markets worried about the stability of PM Johnson’s cabinet after numerous lockdown scandals. Added to this grim domestic picture was the shadow of Brexit and policy going forward in the wake of the resignation of the UK’s chief negotiator, David Frost. All of this was expected to weigh on sterling, especially with thin holiday liquidity exacerbating price action.

Rate hike and relief

Fast forward a few weeks and there may be some light at the end of the (Omicron) tunnel at least. Relief is tangible that risks around the new Covid-19 variant could be more manageable. Indeed, yesterday the UK government did not introduce any new social restrictions into the new year for England, even allowing for record infections and additional measures taken by the devolved governments in other parts of the country.

The surprise rate rise by the Bank of England a few weeks ago has also offered some support to GBP. There was only a one-in-three chance of a 15bp move before that meeting with the economic outlook muddied by the recent introduction of “Plan B” measures. But policymakers are more concerned by the growing inflation risks, with both the labour market and wage growth increasingly more resilient and stronger than expected.

Money market traders have been piling on bets of more rate increases over the next twelve months with markets pricing in four 25bp moves spread broadly across the year. This takes the bank’s terminal rate to 1.25% as the MPC expect a small overshoot to rein in inflation. Sterling was quite oversold before the MPC meeting and the overstretched short side may be offering additional support as traders cover their offside positions. That said, markets are already fully pricing in the maximum number of BoE hikes for next year.

GBP/USD squeezes higher

Technically, a near-term base bult in cable now looks more assured. The broader pattern of trade is bullish after the pound found solid support in the upper 1.31s over the past month with moves below 1.32 petering out as momentum changed direction. The 38.2% Fib level retracement from 2020 at 1.3165 further capped the moves lower.

Prices have recently closed above the September bottom at 1.3411 which could be a signal for more upside. The 50-day SMA at 1.3434 represents the next barrier, with a close above here being the first time since late October. Targets above include the July low at 1.3571 ahead of trendline resistance from the June high above 1.36. We note that the dollar does historically struggle at this time of the year amid thin trading volumes.

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