The Pound Sterling has gained ground against most currencies, except for those from Australia and New Zealand. This rise comes amid worries about the UK government’s large borrowing to cope with rising debt due to inflation. Recent reports show that the government’s borrowing is at its second-highest level since 1993. This raises the possibility of tax increases in the upcoming Autumn Statement. Many are looking forward to the preliminary S&P Global PMI data release on Thursday to learn more about hiring trends within the UK’s private sector, which have slowed down partly due to higher social security costs.

Monetary Policy and Interest Rates

The Composite PMI is expected to be 51.9, a slight decrease from June’s 52.0. This suggests that business activity is still growing, but at a moderate pace. The Bank of England may cut interest rates by 25 basis points at its next meeting in August. Currently, the Pound Sterling is trading near 1.3540 against the US Dollar, which is struggling to gain momentum despite a new trade deal with Japan. The US Dollar Index stands around 97.45, close to its two-week low. The likelihood of the Federal Reserve lowering interest rates in September has dropped recently. This change comes after the US imposed tariffs and the market adjusted its expectations, with the probability of a rate cut standing at 58.7%, down from 69.6%. We believe the Pound’s recent gains are only temporary and may not hold up under significant fiscal pressure. The UK’s public sector net borrowing reached £15.0 billion in May 2024, marking the third-highest amount for that month, which implies that tax hikes or spending cuts are likely ahead. This underlying weakness indicates that the current rally may not be stable. Recent economic data also dampens our outlook for the UK’s private sector. The S&P Global UK Composite PMI for June dropped to 51.7 from May’s 53.0. This reflects the slowest growth in business activity in seven months, particularly in hiring, which makes the economy more susceptible to shocks.

Inflation and Its Impact

UK inflation has hit the 2.0% target for the first time in nearly three years. This opens the door for the Bank of England to take action. We think the market is right to price in a roughly 50% chance of a rate cut at the August meeting. The difference in monetary policies between central banks poses a significant risk for the currency. Given this situation, we expect an increase in GBP/USD volatility. Derivative traders might want to consider buying options straddles or strangles before the central bank’s next announcement. This approach can benefit from significant price movements in either direction, which seems likely given mixed economic signals. In the past, rate cuts have significantly impacted the Pound, even when they were somewhat anticipated. For instance, after the rate cut following the 2016 Brexit vote, the currency saw a substantial drop. A similar, though less drastic, shift could happen if a cut occurs in the near future. Meanwhile, the US Dollar Index is stable above 105.50, supported by a careful Federal Reserve. Persistent US inflation, recorded at 3.3% in May, explains this caution around lowering borrowing costs. The probability of a September rate cut has now leveled out around 60%, according to the CME FedWatch tool, reflecting ongoing price pressures. This difference in policy—one central bank likely to cut rates and the other holding firm—creates a clear trading opportunity. We view this as a chance to use derivatives to capitalize on the US Dollar’s strength against the Pound over the medium term. Buying call options on the USD/GBP pair could be an effective way to take advantage of this trend while managing risks. Create your live VT Markets account and start trading now.

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