Bank of England: Pound Sterling to Find Support on 'Dovish' Outcome says HSBC, NatWest

Published: Thursday, 15 December 2022 06:51
Written by: Gary Howes

50bp expected from Bank of England
'Dovish' guidance also likely
But, GBP reaction function is highly uncertain
NatWest, HSBC says 'dovish' surprise = supportive GBP
TD Securities, Morgan Stanley say the opposite is likely

Image © Adobe Stock

In an unusual twist, the British Pound could benefit from a bearish Bank of England, which is likely to hike interest rates today but signal the 2023 peak for rates will be lower than the market currently expects.

Market consensus has settled on a 50 basis point hike, an outcome that will prove uninspiring for the British Pound as it is universally expected.

A big market move would likely follow a 75bp hike, which would surely propel Pound exchange rates higher as it would be unexpected.

But the composition of the Monetary Policy Committee (MPC) means a 50bp hike will be preferred, leaving it to the guidance on upcoming interest rate decisions to move the market.

The Pound has tended to fall in the wake of Bank of England interest rate and policy decisions from late-2021 and through 2022 because the MPC has tended to underwhelm against market consensus with regards to the scale of the hikes that must be delivered.

Money market pricing suggests investors are expecting a terminal Bank Rate at 4.5%, which implies a further 150 basis points of hiking by the middle part of next year.

If the Bank hints that this is too aggressive an expectation the market will accordingly lower its expectations, potentially taking the Pound lower too.

But this type of market reaction is no longer guaranteed: Sterling's sell-off following November's 'dovish' MPC decision proved shortlived and the currency ended the month notably higher against the Dollar than where it started.

"GBP's reaction to the BoE decision tomorrow will be very interesting. If GBP is able to hold onto its recent gains in the face of a dovish BoE, for example, it would be a clear sign of a more constructive environment for the currency. We favour GBP strengthening on a trend basis," says Dominic Bunning, Head of European FX Research, HSBC Bank plc.

Bunning says signs UK inflation has now peaked could point to a more resilient consumer story later in 2023, particularly if wages remain solid.

"Lower inflation also takes some pressure off the BoE to hike more aggressively and creates less risk of an even deeper UK recession," says Bunning. HSBC are bullish on Pound Sterling against the Dollar in 2023.

Above: Market implied expectations for Bank of England's Bank Rate. Image courtesy of Goldman Sachs.

Paul Robson, Head of G10 FX Strategy at NatWest Markets, says lower interest rates expectations are supportive of the economic outlook and therefore of Sterling.

Falling expectations for Bank of England interest rates in turn push down the yields paid on UK government and commercial bonds, meaning borrowing costs across the economy fall.

This dynamic could therefore offer much-needed support to the economic growth outlook, leading currency strategists at NatWest to say a 'dovish' Bank of England outcome could prove supportive of Sterling.

Robson and his team are bullish the Pound against the Swiss Franc for 2023.

"In fact, the pricing out of tightening would be a positive as it would further reduce fears of a housing market slump and raise hopes of a milder recession. A better inflation/demand profile would make other assets more attractive," says Robson.

The above chart shows Bank rate expectations have been falling since September, at the same time the Pound has rallied, suggesting falling hike expectations could be supportive of the currency.

However strategists at investment bank Morgan Stanley expect a 'dovish' outcome to translate into currency weakness, as per the well-worn playbook.

They expect Thursday's decision to be, on balance, consistent with a fall in Sterling, with the Pound to Euro exchange rate (GBP/EUR) offering the clearest expression of this outcome.

"We express GBP downside risks via long EUR/GBP," says Wanting Low, a strategist at Morgan Stanley in London, in the investment bank's preview of Thursday's event. (If you are looking to protect or boost your international payment budget you could consider securing today's rate for use in the future, or set an order for your ideal rate when it is achieved, more information can be found here.)

Currency strategists at TD Securities are also looking for a weaker Pound against the Euro following the meeting, given the proximity of the European Central Bank (ECB) decision.

"In Europe, we expect a 50bp hike from both the ECB and BoE but see the hawkish risks skewed to the former. That favours upside in EURGBP, as the ECB has the wiggle room to deliver 75bp, while the BoE should disappoint market terminal rate expectations over time," says Mark McCormick, Global Head of FX Strategy at TD Securities.

"High-frequency growth forecasts point to relatively weak prospects in the UK even compared to EUR," he adds.

McCormick says one of the big risks for the British Pound lies in the "vulnerability of the housing market, underscoring the drop in real incomes and higher mortgage rates".

TD Securities does not, however, address whether a lower terminal Bank of England interest rate will be supportive of the housing market, and therefore the economic outlook, as does NatWest.

But the stance to be 'long' the Euro against the Pound is more than a UK-centric stance.

"EZ tail risks have receded, even if the economy remains weak. China reopening favors EZ growth over the UK, especially in the context of housing vulnerabilities. In turn, we argue that the recent dip of EURGBP offers a good entry point to start scaling into long exposure ahead of this week’s event risk," says McCormick.

The Bank of England decision will be delivered at 12 GMT while the European Central Bank is due to make an announcement at 13:15 GMT.