Low note: why the UK pound's fortunes dipped in 2021

Despite an upbeat start to the year, inflation, Omicron and interest rate uncertainty weighed heavily on sterling

The British pound's fortunes rose and fell during 2021. Photo: PA

The British pound has seen its fortunes dip in 2021, falling almost 1.8 per cent against the US dollar as the fallout from the coronavirus pandemic continued to cause uncertainty for the economy.

Sterling started the year in an upbeat mood as Britain made its final exit from the EU, with a further boost coming from the UK’s swift vaccination programme.

But once other countries caught up with their own vaccine efforts, the pound faced a new set of challenges in the summer as inflation started to rise amid the supply-chain crisis while higher interest rates and a surge in Covid-19 cases towards the end of the year caused further headaches.

On December 20, the currency slumped to a one-year low of below $1.32, days after the Bank of England surprised markets by raising interest rates to 0.25 per cent – making Britain the first G7 country to raise rates since the start of the pandemic.

While the currency has since recouped some of its losses, hitting $1.3469 at 08.09am London time on December 30, the outlook remains uncertain as concerns about the UK's economic recovery increase amid surging energy prices, higher Covid-19 cases and post-Brexit tensions over the Northern Ireland protocol.

“Looking ahead to next year, there are two big risks to the economic recovery. First, just like in 2021, the year will start under the rapidly growing shadow of a surge in virus cases,” said Neil Shearing, group chief economist at Capital Economics.

“Second, the supply constraints that have shaped 2021 will probably restrain GDP (gross domestic product) growth at least until the second half of 2022. The big risk is that they last even longer.”

With Mr Shearing expecting the economy to contract 0.1 per cent in December, with a further dip at the start of next year on weaker growth, and interest rates to rise to 0.75 per cent by the end of next year, sterling could be in for a rough ride.

So what has happened over the course of 2021 to lead to this rocky outlook?

Sterling strengthens as Brexit saga finally ends

The start of the year saw sterling rally against the US dollar on Britain’s first day of trading outside the EU, breaking above $1.37 for the first time since May 2018 on January 4, less than two weeks after an EU trade deal was finally agreed on Christmas Eve 2020, cementing new trading rules.

However, with England mired in its third lockdown and similar restrictions in the rest of the country, analysts expected investor enthusiasm to dampen as tougher new measures to control the Covid surge led the nation's population to retreat into their homes once again.

Vaccine optimism saved the day as Britain accelerated its inoculation programme at a rapid pace in a bid to prevent deaths and hospital admissions among the most vulnerable.

By the middle of February, sterling rose to its highest level against the US dollar since April 2018, hitting $1.3899 as the success of the vaccine programme signalled a strong economic rebound for the country.

With the number of people to receive their first dose of a vaccine crossing the 15-million mark and the Bank of England ruling out negative interest rates to help the economy rebalance, it seemed nothing could stand in sterling's way.

"[The British pound] continues to reap the dividends of a successful vaccine roll-out and momentum is building towards a reopening of the economy – probably starting with schools on March 8," Chris Turner, global head of markets at ING, said at the time.

Vaccine optimism and a reopening economy lift pound

By February 19, the pound had already broken through the $1.40 barrier for the first time since April 2018, despite inflation rising to a three-month high of 0.7 per cent in January pushed up by higher food prices and fewer reductions by furniture retailers.

Even a row over the safety of the Covid-19 vaccine made by AstraZeneca and the University of Oxford in early March failed to dent the upbeat mood with the pound holding steady at $1.391 on hopes that Britain's rapid vaccine distribution would reopen the economy faster.

That moment came on April 13, when Britons flocked to the high street to take advantage of shops and restaurants reopening with consumer confidence hitting its highest level in nearly three years.

The momentum helped to lift the pound to a three-month high in May when the country's unemployment rate dipped to 4.8 per cent in the three months to March, with the pound rising above $1.42 for the first time since February in early London trading.

Summer lull sets in as Delta variant emerges

It seemed the pound’s upwards trajectory was unstoppable, after the Bank of England held interest rates at record lows and kept the size of its stimulus programme unchanged in May. The lender said the UK economy was set to enjoy its strongest peacetime growth as Covid-19 restrictions eased, expanding 7.25 per cent in 2021.

However, the celebratory mood was dented in the summer when sterling began to sink against the dollar amid fears the Delta variant of the coronavirus would derail the global recovery, with investors turning their attention to the relative safe-haven of the greenback instead.

“With signs that the global recovery is slowing down amid the resilience of the Delta variant, investors have been reluctantly agreeing with the ‘transitory’ narrative. Consequently, they have been reducing their bets about a sooner-than-expected policy tightening from the Bank of England,” said Fawad Razaqzada, market analyst at ThinkMarkets, at the time.

The falling pound was good news for British expatriates in the UAE who regularly send money to their home country as the pound dipped below Dh5 against the dirham for the first time since January.

The swing below the Dh5 threshold reminded those looking to remit money to the UK of the days when Brexit uncertainty weighed heavily on the UK currency, causing it to dip closer towards the Dh4 mark.

Bank of England flirts with interest rate rise

The pound’s fortunes continued to weaken through the autumn before strengthening as investors priced in an interest rate rise in November to combat rising inflation.

But the Bank of England defied market expectations, holding interest rates at 0.1 per cent on November 4 – despite growing concerns over rising inflation – causing the pound to dip following the decision.

Analysts had widely expected the central bank to increase rates to 0.25 per cent, with the bank’s decision raising questions about its credibility, in particular Governor Andrew Bailey, who allowed speculation for an immediate move in rates to build in the weeks up to the decision.

Mr Bailey was later forced to deny he was an “unreliable boyfriend” with economists accusing him of “appalling signalling” and of sending “muddled” messages after a 7-2 vote that kept rates at the record low of 0.1 per cent.

However, Mr Bailey later insisted that central banks took risks when they sought to provide guidance on what is likely to happen with interest rates during times of economic uncertainty.

“Obviously, in a world which is much more uncertain as to whether things will happen, then it's much more hazardous to give that guidance,” he said in late November.

Then another nail was driven into sterling’s coffin in early December as talk of the British government launching Plan B coronavirus restrictions caused the pound to drop to its lowest level in 2021.

News that Britons would have to wear masks in most indoor venues from December as well as the need for an NHS Covid pass to enter venues where large crowds gather, led to a heavy sell-off as investors feared the move could restrict the UK's economic recovery.

Surprise interest rate bolsters sterling but Omicron emerges

Then the surprise interest rate came on December 16, with the BoE voting to increase rates to 0.25 per cent from 0.1 per cent, sparking a jump in the pound as the market was caught unawares.

Members of the bank’s monetary policy committee voted 8-1 to raise rates a day after inflation soared to a 10-year high, making the BoE the first big central bank to raise borrowing costs since the Covid-19 pandemic battered the global economy last year.

Sterling jumped by three quarters of a cent against the US dollar to its highest since November 30, but the lift was not to last, with investors feeling nervous about the impact rising prices would have on companies’ margins and profits.

“The Bank of England finally raised interest rates by 25 basis points, providing only moderate support to the pound, with sterling being held back by concerns that the economy would weaken as the Omicron variant triggered a fresh wave of restrictions in the country,” Mr Razaqzada said.

Post-Brexit trade worries also weighed on the currency.

"Hovering at just above 1.32 against the dollar, it’s back down at levels last seen a year ago, as tense talks continued about a deal with the EU as the end of the transition period drew near,” said Susannah Streeter of Hargreaves Lansdown on December 20.

However, all was not lost, with sterling vaulting above $1.34 for the first time in a month in the run-up to Christmas and also scaling a one-month high against the euro, as it surfed a general sharp rise in risk sentiment and a steep rise in Britain's short-dated government bond yields.

While UK businesses posted the weakest quarterly growth since the three months to April when lockdowns were in effect, according to the Confederation of British Industry, this was offset by AstraZeneca along with rivals Pfizer-BioNTech and Moderna, saying a third shot of their vaccines work against Omicron.

"We continue to believe that the UK rate market appears well priced at the current juncture for up to four BoE hikes next year," currency analysts at MUFG said in a note.

"It provides a high hurdle for the pound to strengthen on the back of a hawkish repricing of BoE expectations in the near-term, especially as the worst of the new Omicron Covid wave is yet to be seen."

What's in store for sterling in 2022?

Hinesh Patel, portfolio manager at Quilter Investors, is not too optimistic as the currency is hit by political risk as Prime Minister Boris Johnson’s popularity plummets amid a series of sleaze scandals.

“For a currency that has already been beaten up in recent years, we don’t see 2022 as a year of recovery," Mr Patel said.

Stock markets mostly retreated on Wednesday as a "Santa Claus rally" showed signs of fatigue amid lingering fears over the Omicron variant and uncertainty about economic prospects for 2022.

Covid-19 cases have surged across the world, prompting governments to impose new measures to limit contagion while the travel industry faces thousands of flight cancellations.

With Brexit trade negotiations also continuing to cast a shadow over the economy and household incomes set to be squeezed by the soaring cost of living amid higher energy bills, rising inflation and tax hikes, the outlook is far from rosy with Trading Economics expecting the currency to trade at $1.33 by the end of this quarter.

Instead it appears the US dollar will be the winner in the short-term, said Naeem Aslam, chief market analyst at Avatrade, as investors weigh the risks from the coronavirus cases and stay away from "risky currencies like the euro and the pound".

"Investors should understand that the future outlook of the US dollar remains positive because of the faster tapering being executed by the Fed, which would lead to sooner rises in interest rates as well," Mr Aslam added.