This is understandable, as rate differentials are perhaps the only indicator that seems to be reasonably consistent in foreshadowing currency movements. But they are certainly not perfect; nothing is. And right now, they might be giving off misleading signals, at least when it comes to the pound.

This week, we’ve seen the Bank of England cut rates and the Fed hold steady. The ‘law’ of interest rate differentials might suggest that sterling should fall against the US dollar. But even the fact that the BoE rate cut was not fully discounted by the market has been insufficient to weigh down sterling/dollar. Of course, that might happen in time, but we don’t think it will. We look for both the Fed and the Bank of England to cut rates going forward, but even if the BoE cuts faster and by more, we see sterling/US dollar rising to 1.40 and above.

The first point to make in support of this claim is the very general observation that not all rate cuts (or hikes) are equal. For a start, US rate cuts and hikes are different from those of other central banks because they have the capacity to impact global financial conditions and hence risk aversion. We know that when the US cuts rates for the first time, it does not just reduce the rate differential, if US rates are above others at the time and it is the only one to cut. It can also lift global risk sentiment, and if this boosts riskier currencies and weighs down on 'safe’ currencies, like the US dollar, then the greenback undergoes a much greater fall than we would see if this was any other central bank cutting rates.

Of course, this can also work in reverse, via a much stronger dollar when the Fed starts a hiking cycle. But there is a caveat here, and it relates to the reason why the Fed is changing rates. For instance, if the Fed is cutting furiously because some adverse event has occurred, like a pandemic, which simultaneously raises global risk aversion, the US dollar will likely rise.

Indeed, the times when the US dollar rises the fastest also tend to be the times when the Fed is cutting rates the fastest. There is also another caveat to this story, which occurs when other countries are lifting policy rates to try to stave off currency weakness, which is more common amongst emerging market currencies. Rate hikes often lead to a sense of panic and, hence, even more weakness in the currency until, very often, the central bank has to let the currency go.

Bearing all this in mind, why might UK rate cuts now but Fed inaction lead to a stronger pound, not a weaker pound over time? One reason for this is that the Fed will, most likely, start to cut rates in September, and hence the market suspects that it is due some ‘risk-on’ support from Fed policy soon and will likely be reticent to drive the US dollar up now even if the Fed has resisted a rate cut so far.

We also think there is a specific dynamic going on right now that relates to the policy implications of rate changes. In the UK, we’ve just seen a new Labour government installed, and already there are tentative signs that this has lifted economic optimism. In short, the UK’s poor growth performance might be coming to an end, and rate cuts give further weight to the idea that growth could improve. This is important because the UK has been unloved for some time by investors, as shown most clearly by the poor performance of stocks relative to peers.

In the Standard Bank’s view, the rate cuts in the UK are a signal of hope, and that’s likely to lift the pound. Of course, there will be some hope involved when the Fed finally cuts rates, but here, market sentiment seems different. The market seems to fear that slower growth, even recession, is the real threat, and this risk could increase further if it seems that the Fed is falling behind the curve compared to the BoE or the ECB. This, in turn, makes the US dollar particularly vulnerable if economic news underwhelms, and this could start today in the shape of US payroll data.