The Pound Fell After Traders Raised Bets for a Bank of England Rate Cut

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Pound Sterling fell on Tuesday amidst increased bets that the Bank of England would be egged on by the Federal Reserve and cut interest rates again on Thursday.

Money market pricing shows the odds of a second 25 basis point cut from the Bank rose to approximately 33%, having been closer to zero just two weeks prior.

It is apparent that the prospect of a sizeable 50 basis point rate cut at the Federal Reserve on Wednesday is having an impact, with markets thinking the Bank will be tempted to follow the Fed's lead.

The shift in expectations acts as a headwind to UK bond yields and the Pound. The GBP to EUR exchange rate closed lower by a quarter of a per cent on Tuesday at 1.1840. The GBP to USD exchange rate fell 0.42% on the day to reach 1.3160, having been as high as 1.3230 earlier in the day.

In the past, central banks have followed the lead of the Federal Reserve as they look for the cover of the world's most important financial institution when enacting their own policy to minimise idiosyncratic risks.

The odds of a 50bp cut from the Fed have risen over the duration of the last week, prompted by a series of media reports alluding to such. The authors of the reports are known to have strong links to the Fed and are therefore taken at face value.

A rapid pace of Fed rate cuts would bring U.S. interest rates back to a 'neutral' level faster, relieving pressure on the economy. The Bank of England will be conscious that it risks holding onto restrictive levels for too long amidst the easing in financial conditions in the U.S.

Markets expect a gradual approach to interest rate cuts from the Bank of England. But, a risk to the view would be "a more dovish Fed and a weaker Dollar pushing GBP higher and importing disinflation," says Sam Hill, Head of Market Insights at Lloyds Bank. "Arguably what the the Fed does and says today matters at least as much for the November MPC outcome as what the MPC says tomorrow."

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Some analysts have even argued that a slow rate of cuts from the Bank of England relative to the Fed risks bolstering the Pound, which can harm UK exports.

"Under normal circumstances, its peers should be moving ahead with easing, hoping to stimulate their economies with lower rates and ensuring that their own currencies don't strengthen too much against the dollar lest exports be jeopardised," says Geoffrey Yu, an economist at BNY Mellon.

However, Yu says it is no longer certain that the Bank of England will passively follow the Fed, as domestic considerations remain highly relevant.

"Last week's European Central Bank (ECB) decision is a case in point: by all accounts, the ECB’s bias is to remain restrictive, even hawkish. Frankfurt clearly has been unable to shake the notion of “hawkish cuts.” Similarly, the Bank of England is also expected to remain relatively cautious in its decision this week," says Yu.

The Bank of England's Thursday decision follows the midweek inflation report that showed UK inflation rates are rising again. To be sure, inflation was softer than the Bank's forecasts, but it will be difficult to justify cutting interest rates despite clear evidence of persistent price pressures.

"The uptick in August will be hard to ignore for policymakers, and it is this continued stickiness in services that underpins the modest probability of a second rate cut priced in by markets tomorrow. The data should move in the BoE's favour into next year, but for now, there is enough reason to keep the rate cuts gradual," says Kyle Chapman, FX Markets Analyst at Ballinger Group.