Blog Posts — September 20, 2022

Higher interest rates will not save the pound—nor will a weaker currency prop up the UK stock market 

by Christoph Schon, CFA, CIPM

Conventional wisdom has it that higher interest rates make a currency more attractive to foreign investors, whereas a weaker exchange rate can be good news for export-oriented economies. Neither is true for the United Kingdom right now. Despite the Bank of England is expected to raise its base rate to similar heights as US federal funds, the pound could extend its recent losses against its American rival even further. And although a weaker currency has been good news for British blue chips in the past (e.g., after the Brexit referendum), the UK’s large trade deficit is likely to put more downward pressure on the pound, while also fueling inflation. Our stress tests generated in Axioma Risk™, therefore, indicate that additional stock market losses could well be in store. 

Higher Bank of England base rate ≠ stronger pound

Since September last year, traders around the world have dramatically upped their monetary policy expectations, from anticipating almost no action from central banks 12 months ago to multiple percentage points in rate hikes now. The green line in Figure 1 shows the ICE 3-month Sterling Overnight Index Average (SONIA) future expiring in March 2023. The implied interest rate can be calculated by subtracting the price on the right-hand scale from 100. The current futures price of around 95.65, therefore, translates into a rate of 4.35%. 

Figure 1. GBP/USD versus monetary-policy expectations 

Sources: Qontigo, Intercontinental Exchange

Plotting these rate expectations against the recent development of the GBP/USD exchange rate (in blue) shows that tighter monetary conditions have so far been weighing on the pound. This contradicts the customary notion that higher rates make a currency more attractive to foreign investors. But even the fact that the Bank of England is now expected to raise its main policy rate to similar levels as the anticipated peak in US federal funds and higher than the European Central Bank’s deposit facility (Euribor futures imply 2.75% in spring next year), this seems to have done little to halt the pound’s fall. 

Weaker pound = more competitive UK companies?

There could, of course, still be the hope that a weaker exchange rate will eventually make UK companies appear more competitive relative to their foreign competitors, as it did in the aftermath of the Brexit referendum. In the four months following the British vote to leave the European Union on June 23, 2016, the pound depreciated 18% against the US dollar. Over the same period, the STOXX® UK 180 blue-chip index gained more than 10%, and the inverse relationship largely prevailed until the outbreak of the COVID-19 pandemic in early 2020. The argument at the time was that the index was dominated by large international corporations that derived a significant part of their revenues from abroad. The weaker exchange rate also made UK assets seem cheaper to foreign buyers. 

The last 2.5 years, in contrast, have been dominated by global flows in and out of the USD: first, the safe-haven buying at the onset of the pandemic and then the subsequent unwinding of those positions as markets recovered over the remainder of 2020. More recently, the greenback has been buoyed by multiple “jumbo” rate hikes from the Federal Reserve and the growing divergence of economic-growth projections on either side of the Atlantic in the wake of the Russian invasion of Ukraine. 

Figure 2. UK share prices versus pound 

Source: Qontigo

Since the start of this year, the pound has depreciated around 15% against the US dollar, yet the UK stock market has held up comparatively well, thanks mostly to its large exposure to the oil and gas sector. However, the latest data from the Office for National Statistics showed that the country’s trade deficit remained near all-time highs, primarily as a result of a surge in energy imports in the wake of the Russian invasion of Ukraine. As most of the imported goods are paid for in foreign currencies—most notably USD—this is likely to add even more downward pressure on the pound, which will, in turn, make foreign goods and services even more expensive for British firms and households and thereby further fuel inflation. 

The strong negative return of the UK Exchange Rate Sensitivity factor from the Axioma United Kingdom Equity Factor Risk Model – Medium-Horizon (UK4-MH) over the past three months also confirms the notion that exporters, whose products and services appeared cheaper to foreign buyers because of the weaker exchange rate, have been faring much better than importers in the recent environment. Given the current strong positive correlation between the STOXX® UK 180 index and the GBP/USD exchange rate, we can, therefore, expect a further depreciation of the currency to push share prices even lower. 

Higher interest rates + weaker pound = bad news for UK assets

To see how a weaker currency and higher interest rates could affect UK assets going forward, we performed a stress test in our Axioma Risk™ platform. The results in Figure 3 indicate that shocking GBP/USD down by a further 5% could translate into a 2.6% loss for UK equities. GBP-denominated fixed income assets are also expected to suffer from a weaker exchange rate, with prices for nominal and inflation-linked Gilts projected to decline between 0.5% and 1%. Simulated losses for corporate bonds are even greater, with credit spreads expected to widen, as share prices fall. The transitive stress tests used were calibrated on daily returns over three months ending September 7, 2022. The bond returns were normalized to an average duration of 7 years. 

Figure 3. Simulated returns for selected GBP assets 

Source: Qontigo

The second scenario simulates the impact of further Bank of England rate hikes on top of what is already priced in for March 2023. For each additional 25 basis points in the base rate, long-dated sovereign and corporate bonds are projected to lose around 1%. The predicted price decline is slightly smaller for high-yield debt, due to the more moderate impact on the stock market, which displays a 0.3% downturn. The pound can also be expected to move lower, with a -0.4% depreciation for each quarter-point rate increase. Unless the BoE defies current expectations, investors in UK assets are likely to be in for a bumpy ride.