Pond awaits direction and looks at two fronts

For the British pound, the coming weeks will revolve not around one, but around two decisive factors: the Bank of England's interest rate decision and Prime Minister Keir Starmer's political course towards Europe.

Anyone with a savings account knows how satisfying it can be to find a bank where the interest rate is just a quarter of a percent higher. Major financial institutions play a similar game at a somewhat higher level. If interest rates in one country are higher and rise faster than in another, this can set a significant flow of capital in motion. For the time being, the United Kingdom has a slight edge over the European mainland in this regard. The Bank of England (BoE) maintains a policy rate of 3,75%, while the European Central Bank's (ECB) deposit rate currently stands at 2,0%. That interest rate difference is a major reason why the pound has gained some ground against the euro over both the past twelve and 24 months.

Why did the pound become slightly more expensive?
This coming Thursday, a glimpse will be revealed of whether this difference will widen or narrow in the near future. The Bank of England Board will meet then to make a decision on interest rates. Incidentally, it would be very unusual for interest rates to be tampered with. On the one hand, inflation has been 1 percentage point or more above the official target of 2% for almost a year. Energy prices, which have risen sharply due to the war in Iran, are further stoking the fire of inflation. In theory, therefore, an interest rate hike would be a logical move. But an interest rate increase throws not only a bucket of cold water on the inflation fire, but also on economic growth. After all, it becomes more expensive for companies and consumers to borrow money, causing consumption and investment to decline somewhat.

extinguishing the last remnants of growth
In mid-April, the IMF already lowered the target for British growth in 2026 from 1,3% to 0,8%. The Bank of England therefore runs the risk of extinguishing the last vestiges of economic growth with an interest rate hike. On the other hand, the inflation outlook leaves little room for an interest rate cut. It would be surprising if the focus in the currency world did not shift to political developments following the British interest rate decision. In this regard, the rapprochement Starmer is seeking with Europe is attracting particular attention. It was recently announced that he intends to introduce new regulations that would allow the Labour cabinet not to submit all new European legislation to Parliament. This creates room to quickly strengthen ties with Europe.

Door ajar
Reduced trade friction, lower costs, and greater investment certainty could improve the growth potential of the British economy. Moreover, it would make the country more attractive to foreign investors. However, it also leaves the door ajar for the opposition to attack Labour for allegedly undoing the Brexit agreements. In some tabloids, voices are even already being raised calling for a new referendum, given that leaving the European Union has primarily resulted in significant economic pain. Consequently, the pound finds itself at a crossroads. On one side stands a central bank that may have to pursue a tight policy for longer than expected. On the other is a government attempting to restore the economic relationship with Europe. As long as this does not change, the currency will likely continue to hover 'in no man's land' around €1,15.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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