Omicron Spells Bad News for the Pound

There’s trouble brewing for the pound as the U.K. tightens its coronavirus restrictions once again.

Sterling is heading for its first yearly loss since 2018 as Prime Minister Boris Johnson advises people to work from home to help curb the spread of the omicron variant. The measure is stoking fears about the country’s sputtering recovery and forcing traders to pare back bets on a Bank of England rate hike on Thursday – which just weeks ago looked like a done deal.

Mizuho Bank Ltd., MUFG and Canadian Imperial Bank of Commerce see a deeper decline toward $1.30 or beyond in the coming weeks, while sentiment in the options market is close to the most bearish in 12 months.

Unlike their peers in other major currency markets, pound traders are having to recalibrate their expectations for central bank policy. Parts of Europe face far stricter lockdowns, yet there is little question the European Central Bank will remain dovish. And in the U.S, hawkish expectations for the Federal Reserve continue to build, lifting the dollar.

“Up until recently we had a December hike and a zero-lockdown scenario as bolted on for the U.K.,” said Neil Jones, head of foreign-exchange sales to financial institutions at Mizuho, who expects sterling to fall to $1.295, its weakest in 13 months. “This week has seen an abrupt 180 on the rate- and Covid-trade as far as the pound is concerned.”

Nerves are fraying. The cost of hedging swings in the pound going into the BOE decision is at its highest in more than nine months, with money market traders betting an increase in borrowing costs won’t come until February.

“Cautious comments from BOE officials and further covid restrictions mean that it’s more likely to delay raising rates until there’s more clarity on omicron’s impact,” said Lee Hardman, a strategist at MUFG who expects sterling to dip toward its lowest since November 2020, when fears prevailed that a Brexit deal couldn’t be reached. “In contrast we expect the Fed to speed up tightening plans next week.”

Strategists are paring back their targets for the pound, though they may still be playing catch-up with the news cycle. They’ve slashed their forecasts by nearly 4% to $1.35 for the end of March, compared with $1.40 three months ago, according to the median forecast in a Bloomberg survey.

For Citigroup Inc., the pound is the least preferred Group-of-10 currency against the dollar with a fair value of $1.29, more than 2% weaker from current levels, according to Global Head of Foreign Exchange Analysis Ebrahim Rahbari.

Not everyone is so bearish. While Barclays Plc expects the BOE will start raising rates in February, passing on Thursday’s meeting is not going to cause “much of a disappointment for financial markets,” said Eimear Daly, an analyst at the firm.

“We think the pound is going to benefit from inflation peaking in the first half of next year,” she said. “And growth has actually been relatively resilient in the U.K.”

Downing Street Chaos

Still, a further rethink about the BOE’s ability to tighten next year could be in store. And investors are beginning to take note of the political turmoil engulfing the prime minister after his staff were accused of breaking lockdown rules with a Christmas party last year.

“The market has priced in too many rate hikes in 2022 given the headwinds that face the economy in the form of rising food and energy prices and the national insurance tax hike,” said Jane Foley, head of foreign-exchange strategy at Rabobank. “The chaos in Downing Street is not a positive factor for sterling and could increase the reluctance of investors to buy into post-Brexit Britain.”