Spectrum FX Daily Market Update

Sterling trades at two-month highs on hawkish BoE bets

Action in the foreign exchange market has been relatively quiet so far in 2022, although activity is expected to pick up following the typically quite Christmas and New Years period.

We think that the key theme in financial markets this year is likely to centre around the extent and persistence of the overshoot in global inflation, and the response of central banks in light of the spike in prices. This narrative has already begun to play out in the past few trading sessions as both the Canadian dollar and UK pound, whose respective central banks are expected to raise interest rates more aggressively than almost all of their G10 peers, have topped the performance rankings.

Sterling has performed particularly well in the first ten days of 2022, rising towards the 1.36 level versus the US dollar to its strongest position since early-November on Monday. Not only has sterling continued to benefit from the Bank of England’s surprise 15 basis point rate hike in December, but the near-unanimous 8-1 vote suggests that another hike in February, and aggressive pace of policy normalisation during the rest of the year, is very much on the cards. The main stumbling block to hikes prior to the December meeting was the impact of omicron on the UK economic recovery. That impact does, however, look likely to be relatively minimal given the UK’s impressive booster vaccine rollout and lack of additional restrictions in England. This appears to have supported sterling in the past few sessions, with the currency trading higher against every other major currency.

Across the Atlantic, the dollar has found gains a little bit harder to come by in the past week or so, despite the recent sharp increase in US yields. The 10-year Treasury yield is up almost 30 basis points since the start of the year alone, although the dollar has underperformed most of its G10 counterparts. This may perhaps be due to the already lofty bets in favour of Federal Reserve policy tightening - Fed fund futures now see around an 80% chance of a first pandemic era rate increase from the Fed in March and around a 50% chance of four hikes over the course of the year. The problem for the greenback is that the gap between market pricing and reality now looks relatively narrow, and that could provide a stumbling block for dollar strength. As always, tomorrow afternoon’s US inflation data will be closely watched, although it would likely take a blowout number for the dollar to post any meaningful gains.

Meanwhile, EUR/USD continues to be stuck in a very narrow range that it has held since late-November. On the one hand, the pair should be rallying on the general improvement witnessed in risk sentiment in the past few weeks as more and more evidence suggests that the omicron strain of COVID-19 poses minimal downside risk to the global economy. The issue for the common currency is that authorities in Europe have been among the most cautious in response to the variant, with a handful of countries in the region tightening restrictions since Christmas, including Germany. A couple of speeches from ECB President Lagarde could break EUR/USD out of its recent slumber this week, although aside from any surprises here we think that Wednesday’s US inflation print will be the most important development for the pair.

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