British Pound Forecast to Climb Further by Bank of America

Those watching the currency markets in the hope of (or fear of!) a stronger pound sterling should take note of new research from a leading foreign exchange research house.

The British pound could soon begin the next leg of its longer-term move higher as the issue of interest rate rises in the UK are brought to the fore suggest Bank of America Merrill Lynch Global Research in their most recent update concerning the UK currency.

Expectations on interest rates matter - it is no coincidence that the uptick in rhetoric from the BoE and the Fed coincided with strong appreciation of both USD and GBP over the second half of July.

This GBP and USD out-performance remains intact as we enter August.

“We continue to believe the policy divergence theme (ie. rising rates in the UK relative to falling rates elsewhere, in for instance Australia and New Zealand) will support the case for renewed GBP gains particularly on the crosses,” says Kamal Sharma at Bank of America Merrill Lynch Global Research.

In 2015, the Bank of England is once again guiding the market into rate hike expectation mode.

“Our UK economics team forecasts a February 2016 lift-off date with gradual tightening through to year-end while our US economists continue to look for a September lift-off from the Fed,” says Sharma.

Bank of America point out that there is a 90% correlation between Fed and Bank of England monetary policy cycles and the preference for the BoE to historically follow.

Markets are widely predicting the US Federal Reserve to start raising rates in September of this year which leaves open a potential rate hike in November.

December is unlikely owing to proximity to the new year, as is January. February is the next logical step.

In two separate speeches over the past few weeks, Bank of England Governor Carney has highlighted that crunch time is approaching for the BoE: “The decision as to when to start that process of raising interest rates will likely come into sharper relief around the turn of this year”.

The once arch-dove on the MPC, David Miles also stated the time for normalisation of policy was approaching.

Rising Interest Rates Matter for the Pound Sterling

The evidence from Bank of America’s analysis shows GBP values generally continue to appreciate following the start of a tightening cycle.

It is noted that in the last three episodes of BoE tightening (1999, 2003 2006, which coincide with the Bank of England gaining operational independence) the pound has been broadly higher in the 90 days following the start of a rate tightening cycle.

“In our view, without the natural counterweight of other central banks entering into a similar tightening cycle, widening UK rate differentials could continue to support the case for further GBP appreciation,” says Sharma.

Markets are Under-Pricing the Pound

A February lift-off and an average 18-month tightening cycle leaves markets under-estimating the strength of the pound sterling it is argued.

The UK rates market is pricing in 1.5% for the base rate by August 2017.

That is, a 1% increase in rates over 18 months, which is slower than average point out BofA Merrill Lynch.

“Our point here is that despite the recent uptick in BoE rhetoric, the UK rates market has not priced in an overly aggressive rate profile for the UK, which once again reassures us GBP strength has not been built on an increasingly hawkish scenario for the UK rate tightening cycle,” says Sharma.

Forecasting the Pound Sterling to Strengthen

What does this all mean for the British pound then?

The analysis suggests GBP has historically continued to perform well even after the start of a tightening cycle.

“The fact broader market positioning is not currently an impediment to renewed GBP upside combined with a relatively benign profile for UK rate hikes next year is reassuring and we reaffirm our bullish GBP view on the crosses where policy divergence is most obvious,” says Sharma.

“EUR/GBP has bounced impressively from its 0.6936 low, but looks rich relative to rate differentials. Though not in overbought territory, we would look to fade any further risk-off induced rally toward 0.7150, and reaffirm our 0.67 year-end target.”

The bullis forecast comes as we witness the pound make fresh inroads against the euro with its 2015 best coming into view once more.