Pound / Euro Could Surpass 1.19 Under Hawkish BoE Decision & Guidance: Analyst

• Market expectations for rate hike back to 50%
• BoE will be torn between surging inflation / Omicron
• ING 'war gaming' for GBP/EUR shows differing paths

Image © Adobe Stock.

The British Pound has ticked higher over recent days in a sure sign that markets have been steadily rebuilding expectations for a rate hike at the Bank of England today.

A failure to raise rates could therefore potentially see some of these recent gains given back, although a pressing need for higher rates given surging inflation levels could yet keep dips shallow according to analyst projections.

A look at the OIS market - a financial futures contract market that offers the clearest available gauge of market interest rate expectations - shows the odds of a December hike fell to around 30% around the 9th of December.

It had been as high as 90-100% in late November.

But two days of consensus-beating data from the UK economy has since pushed expectations higher again to just above 50%, as shown in the below chart:

Image courtesy of Pantheon Macroeconomics.

The chart above from Pantheon Macroeconomics suggests markets raised expectations for a hike started building after Tuesday's labour market data confirmed there was no jump in unemployment following the closure of the government's Covid jobs support scheme in September.

But it was inflation data for November that really reawakened markets to the need for a rate hike: inflation is running at 5.1% year-on-year and looks set to breach 6.0% in coming months.

"After yesterday’s strong inflation numbers for November markets shifted Feb back to being fully priced for a 25bp hike, but we think that the risk of inflation expectations de-anchoring will lead to a symbolic hike today," says Peter Chatwell, Head of Multi-Asset Strategy at Mizuho Bank.

The Bank of England is tasked with keeping inflation anchored around the 2.0% levels and markets are betting the ability to argue for emergency record-low rates in an environment of sweltering inflation is simply untenable.

The Pound to Euro exchange rate recorded a low at 1.1638 on Dec. 09 and has since recovered to 1.1736 amidst the tick higher in rate hike expectations.

The Pound to Dollar exchange rate has maintained a flatter profile, holding around 1.32-1.3250 amidst a broader rally in the U.S. Dollar.

• High street bank rates (indicative):
  GBP/EUR: 1.1516 \ GBP/USD: 1.2968
• Payment specialist rates (indicative): 1.1686 \ 1.3173
• Find out more about specialist rates, here
• Set up an exchange rate alert, here
• Book your ideal rate, here

"Should the central bank decide to raise rates, GBP/USD could surge towards $1.35 by the end of the week, whilst GBP/EUR could by on the prowl for a fresh 2021 high. On the flip side, any inaction is likely to prove temporary so the downside risk for sterling based on this event may be limited," says George Vessey, Currency Strategist at Western Union Business Solutions.

Pound Sterling Live has a decent amount of FX and strategy research to sift through which offer predictions as to how the Pound might react to the various decisions the Bank delivers on Thursday.

But short-term price action will ultimately depend on the degree to which the market was, or was not, anticipating a rate rise in the lead up to the decision itself: the surprise factor always carries the day.

Therefore if market odds rise in the 24-48 hours ahead of the decision any short-term tactical research that was written based on a different set of market assumptions/information/expectations fast becomes redundant.

Once odds for a hike approach fully-priced levels the Bank must deliver on expectations and hike in order to maintain any gains made by the currency in the lead up to the decision.

By the same token, if odds for a hike are towards 30% or lower a rate hike would come as a surprise and would be expected to jolt the currency higher.

If the market is priced at around 50-50 then the currency reaction might be less severe to either a hike or no-change decision: if any gains or falls follow the decision they will likely be faded over subsequent days.

On the basis of current pricing therefore the post-MPC decision might be as benign as can be expected for Sterling.

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However, there is more to a Monetary Policy Committee decision than just the decision on interest rates: what is the tone set regarding future decisions?

A bullish outcome for Sterling could involve the Bank signalling an intention to raise rates rapidly in the new year once the Omicron wave has passed and normality starts to resume.

They might also lean on recent inflation data to push the need for a higher 'terminal' rate than had previously been envisaged.

The Pound would likely trend higher over coming days and even weeks under such a scenario.

But a message of caution with heavy emphasis on the need to watch the pandemic and a desire to keep medium-term rate expectations subdued could be taken as a 'bearish' signal, and the Pound could give back recent gains and enter 2022 on a soft footing.

ING's UK Economist James Smith says he holds an assumption the Bank will keep interest rates unchanged on the basis they need to wait for more information regarding Omicron.

The Bank is however expected by ING to signal the need for rate hikes at subsequent meetings, which would limit any significant downside in Sterling.

ING strategists see the Pound-Euro exchange rate at around 1.1765 following such an outcome.

Above: GBP/USD at daily intervals (top) and GBP/EUR at daily intervals (bottom).

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A bullish case for the Pound would involve a rate hike - but with a split decision - and a signal that further gradual future rate hikes are required.

ING strategists see Pound-Euro going to 1.19 under such an outcome.

A more bullish outcome would be an unanimous decision by the MPC to hike and a communication that a rate hike in February is required.

Pound-Euro could go to 1.1976 under such an outcome says ING.

And what could send the Pound lower?

A 'dovish' outcome would see the Bank reach an unanimous decision to keep Bank Rate unchanged at 0.10% delivered alongside the message that the Omicron variant will significantly alter UK economic growth.

They would also signal there will be a requirement for rate rises in coming months.

Under such a scenario the Pound-Euro exchange rate is forecast by ING to fall to 1.17.

"Either way, we expect the Bank to reiterate that it plans to hike rates in 'coming months', though we think officials will be keen to keep options open on the exact timing," says Smith.