Pound Sterling Rallies After Bank of England Kills Negative Interest Rate Prospects

- "BoE can’t afford to sink sterling" - Quilter Investors
- Money markets no longer expect negative rates in 2021
- GBP is top performing currency in wake of decision

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• Market rates at publication: GBP/EUR: 1.1414 | GBP/USD: 1.3676
• Bank transfer rates: 1.1194 | 1.3393
• Specialist transfer rates: 1.1334 | 1.3580
• More about bank-beating exchange rates, here

The Bank of England has opted to not cut interest rates into negative territory, and has done so with an unanimous vote of the Monetary Policy Committee (MPC).

The initial decision and subsequent guidance from the Bank has prompted a rally in the British Pound against the Euro, Dollar and other major currencies.

In Pound Sterling Live's preview reports we noted currency analysts were warning foreign exchange markets would have likely sold the Pound had the Bank opted to cut interest rates, or had some members of the MPC voted for a rate cut.

Therefore, the decision is on balance supportive of a rise in the value of Sterling.

The MPC also voted unanimously to keep quantitative easing levels unchanged.

"This is positive for GBP as (a) negative rates are not imminent and (b) with all eyes on a second quarter economic recovery in the UK, such rate cuts probably wouldn't be necessary in six months (when operational risks fade) from a macro point of view. Hence, we see the market pricing out the odds of negative rates, benefiting GBP," says Petr Krpata, Chief EMEA FX and IR Strategist at ING Bank.

The Pound-to-Euro exchange rate jumped to new eight-month highs at 1.1425 following the decision, the Pound-to-Dollar exchange rate recovered back to 1.3676, having been under pressure owing to the broadly stronger Dollar.

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Justifying the decision to keep policy settings unchanged, a statement from the Bank revealed UK economic growth is projected by the Bank to recover rapidly towards pre-Covid levels over 2021, as the vaccination programme is assumed to lead to an easing of Covid-related restrictions and people’s health concerns.

Furthermore, projected activity is also supported by the substantial fiscal and monetary policy actions already announced by the government.

Further out, the pace of GDP growth is forecast to slow as the boost from these factors fades, but spare capacity in the economy is expected to nevertheless be eliminated as activity picks up during 2021.

These projections eliminate a need for lower rates and more quantitative easing.

The Bank also indicated it was surprised by the strength in economic performance towards the end of 2020, noting it expects UK GDP to have risen a little in the final quarter of 2020 to a level around 8% lower than in the final quarter of 2019.

They note this forecast is materially stronger than expected in their November Monetary Policy Report (MPR), when the Bank's economists last released their forecasts.

The Pound has rallied as the market cut expectations for negative interest rates in the near future, analyst Eric Bregar at Exchange Bank of Canada points out that money market pricing now shows that negative overnight rate speculation has disappeared from the 2021 OIS curve.

The developments seen today therefore likely provide some further underpinning to Sterling's 2021 rally.

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"While the market pricing for negative interest rates has persisted for some time, today the Bank of England has quashed the idea of rates going sub-zero, at least for now. We would have to see significant economic weakening in the UK for them to become a reality, and with inflation expected to tick up as the year goes on, the BoE can’t afford to sink sterling as we get back into recovery mode," says Hinesh Patel, portfolio manager at Quilter Investors.

"There are reasons to be optimistic as a UK investor. With the hugely successful vaccination drive and supply issues being overcome, it’s not unrealistic to believe the second half of the year will produce the return of consumer confidence. With recent economic data also beating estimates of late, it could be that we are past the point of peak pessimism," he adds.

The Monetary Policy Report saw the Bank's economists downgrade near-term growth, but raise forecasts for the remainder of 2021 through to the end of the first quarter of 2022:

Above: The Bank's current forecasts vs. forecasts make in November contained in brackets.

"The latest decision from the Bank of England keeps the door open to negative rates, though only after a six-month period of industry preparation. But optimistic growth forecasts suggest that a foray into sub-zero rates is increasingly unlikely in the current cycle," says James Smith, Developed Markets Economist at ING Bank.

The Bank of England said that while it is not yet willing to cut interest rates to 0% or below, such an outcome could yet happen in the future and such a move is in fact now part of their toolkit.

Should the post-pandemic bounce back in economic activity fail to transpire as expected, the Bank would perceivably cut interest rates and boost quantitative easing once more.

The outlook for the UK economy, interest rates and Pound exchange rates therefore rests with the progress of the country's vaccination programme which for now looks to be on course.

Some analysts say it is only a matter of time before the Bank cuts rates again.

"It’s my view that with the economy how it is, and the hint-dropping from Bank of England, rate cuts are looming as it’s increasingly clear that the quantitative easing agenda is not sustainable," says Nigel Green, CEO of de Vere Group. 

Green says if interest rates are cut to 0% or lower the effect would be to stoke a rise in equity markets as investors rotate out of cash.

“Whilst the debate on whether negative interest rates help the ‘real economy’ or not will continue, there is no doubt that they would help boost financial asset prices," says Green.

“With this now front and centre in their minds, investors will now be looking to top-up their portfolios before the next round of cuts and the likely subsequent price increase. They’ll be moving to capitalise on the lower entry points now before the next significant rally," he adds.

Green says those with savings in the bank are already getting no return thanks to the ultra-low interest rates and the threat of negative rates will offer them more reason to increase their exposure to stocks.