News headlines out of the foreign exchange market have become increasingly dominated by one thing: rising inflationary pressures globally.
An imbalance between an unleashing in pent-up demand and acute supply shortages, coupled with rising commodity prices globally, have sent consumer prices sharply higher in many instances. In the US, headline inflation rose back up to its highest level since 2008 in September, with price growth in the Eurozone and UK also spiking to nine- and thirteen-year highs respectively. A good gauge of this jump in inflationary pressure is Citibank’s G10 Inflation Surprise index, which rose to its highest ever level last month
The euro has sold-off against the US dollar since June, with the EUR/USD pair slipping below the 1.16 level for the first time since July 2020 in late-September (Figure 8).
The common currency has been among the worst performers in the G10 in the past few months, we think in large part due to recent communications from the European Central Bank. The ECB has been very dovish, and looks unlikely to raise interest rates any time soon, despite a broad recovery in the Euro Area economy and recent pick-up in domestic inflation.
Sterling remains one of the better performers in the G10 so far in 2021, although the pound has lost a bit of ground of late and briefly fell below the 1.35 level versus the US dollar in late-September for the first time since January.
Investors have taken a generally bullish view towards the UK currency in the past few months on optimism that Britain’s economy may be set to outperform its major peers in 2021. This optimism comes off the back of the removal of almost all of the UK’s virus restrictions in July, with the easing in measures taking place at a much swifter pace than pretty much every other country in Europe. The Bank of England also looks almost certain to raise interest rates much sooner than both the Federal Reserve and the European Central Bank, which should be supportive of our call for a broadly stronger GBP over our forecast horizon. The latest communications from MPC members strongly support our view, and it seems likely that interest rates will go up before the end of 2021.