British Pound Stabilises after Bank of England Sticks with Commitment to Raising Interest Rates

Changes in rates are normally only made in response to movements in inflation, which is sensitive to growth, but impact currencies because of the push and pull influence they have over capital flows. Those flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency.  

The BoE has said ever since 2017 that inflation is set to test the 2% target repeatedly over the coming years and that rates will need to rise in order to prevent prices running ahead of the target for too long. However, prices surprised on the downside in August and even the BoE now expects the consumer price index to run below the 2% target for a while up ahead.

But the bank is also constrained in its decision making by considerations of what might happen to the Pound in the event that it abandons the pledge, or claim, to be looking to raise interest rates. With that commitment helping to spare Sterling from further losses, most of which have been Brexit-related of late, getting rid of it would risk an inflationary spiral in UK exchange rates that would raise import prices and could end up driving inflation above the target. 

Above: Timeline of UK inflation developments and drivers. Source: Pantheon Macroeconomics.

"Minutes of September’s MPC meeting are significantly more dovish than August’s. The summary emphasises that the outlook for global growth has deteriorated and that in the U.K., “a degree of excess supply appears to have opened up within companies” that likely will continue to build," says Samuel Tombs, chief UK economist at Pantheon Macroeconomics. "A case eventually could be made for cutting Bank Rate. The Committee has not formally revised down its forecast for GDP growth in Q4 and beyond, but the minutes certainly give the impression that its base case has changed from one of a Brexit deal being agreed in the near future, to long-lasting Brexit uncertainty.

Inflation pressures are dissipating and the economy is under pressure from political uncertainty at home and an external slowdown in growth abroad. Furthermore, and with no definitive end to the Brexit Saga in sight, the BoE has warned a prolonged period of uncertainty over the shape of the UK's eventual new relationship with the EU will increasingly weigh on growth up ahead. 

Taken together and at first glance, those factors should be enough to make the BoE's commitment to an "ongoing tightening" of monetary policy difficult to sustain, but concerns over the inflationary impact of movements in the exchange rate as well as the sheer gulf between the likely states of the economy under either a 'no deal' Brexit and a negotiated exit have so-far discouraged the BoE from adjusting its interest rate stance.

"The Committee still is in wait and see mode and it is not going to take pre-emptive action. If, as we expect, the near-term data surprise the Committee’s expectations to the upside, the MPC will stand pat. In particular, its forecast for quarter-on-quarter GDP growth of just 0.2% in Q3 is puzzlingly low, following July’s rebound; our forecast remains 0.4%," says Pantheon's Tombs. "The Committee still hasn’t been able to agree what the appropriate response to a no-deal Brexit should be...Our view remains that the doves would win out and Bank Rate would be cut to 0.50% in the first meeting after no-deal, 0.25% in the second and 0.05% in the third, but with the Committee split, much will depend on if Mr. Carney has been replaced by then." 

Above: Pound-to-Dollar and Pound-to-Euro rates (orange line, left axis) at weekly intervals. 

Parliament has been suspended and the two sides of the Brexit divide are this week wrestling in the Supreme Court over whether the decision to end the current parliamentary session via prorogation was legal. All of thise is taking place as the clock ticks down toward deadlines on October 19 and October 31 that will be key to the next developments in the Brexit process. 

Opposition MPs and 'rebels' from within the governing Conservative Party, with help from an apparently partisan Speaker of the House of Commons, succesfully hijacked the parliamentary agenda this month and imposed upon the government legislation that requires Prime Minister Boris Johnson to request a third Brexit delay no later than October 19 if an exit agreement has not been reached with the EU up until that point.

If such a request is not approved by October 31, and a deal not agreed, a 'no deal' Brexit will take place 11:50 on Halloween. Most analysts say that would lead to further punishing losses for Sterling, with the Pound-to-Dollar rate tipped to fall below 1.15 and as far as 1.05 while the Pound-to-Euro rate heads toward parity. Both exchange rates are already half way toward those levels, from where they were back in February when a deal looked to market as if it was likely, reflecting a hefty implied probability.

"We are overweight the British pound versus the US dollar. While we do not seek to predict the ultimate outcome of the Brexit process, our view is that the FX market has been overpricing the risk of a no-deal Brexit at the end of October. We believe that strong opposition to such an outcome in the UK Parliament is likely to lead to a delay. Recent political developments support this view; UK lawmakers voted for legislation to force Prime Minister Boris Johnson to request a postponement from the EU if he fails to negotiate an agreement. If our base case for an extension to the 31 October deadline proves correct, we expect further upside for sterling," says Mark Haefele, global chief investment officer at UBS Global Wealth Management.