The Pound’s Hurting, for a Simple Inflation Reason

(Bloomberg) --

The pound, which ended last year with a bang, has started 2022 with a whimper. Its travails may continue until the Bank of England is able to quell expectations about inflation.

Sterling has declined about 1% against the dollar so far this year as fears about price pressures mount. Pound-denominated five-year zero-coupon inflation swaps, which were trading around 4.72% on Dec. 15 -- one day before the BOE first raised rates in the current cycle -- are now about 5.30%. The five-year inflation breakeven rate has climbed in similar fashion.

In other words, even though the BOE has raised rates by 40 basis points so far, inflation expectations have failed to moderate. That isn't very surprising given that retail-price inflation is running at almost 8%. And given the surge in commodity prices stemming from the sanctions on Russia, price pressures may yet increase. If anything, the pound's travails are a reflection of fears that inflation expectations could be getting unanchored.

In contrast, the dollar is getting a boost from improving real yields. For instance, five-year dollar real yields had almost doubled this year before retreating of late, suggesting that the augury for cable could have been worse. However, with Fed Chair Jerome Powell sticking to his guidance on the rate trajectory ahead, the equation may yet move more emphatically in favor of the dollar.

Unless the BOE is able to contain inflation expectations, spot GBP/USD will have to be content with treading water, perhaps with a weaker bias stemming from the fallout of Russian sanctions. However, sterling faces better prospects against the euro given that the European Central Bank wouldn't be as willing to start raising rates until there is better clarity on how the Russia-Ukraine war and the sanctions will impinge on liquidity needs in the euro area.

NOTE: This was a post on Bloomberg's Markets Live blog. The observations are those of the blogger and not intended as investment advice. For more markets analysis, go to MLIV.