British Pound Rallies as BoE Points to Potential August Rate Rise - But is the Bank Just Bluffing?

The Bank of England surprised financial markets on Thursday June 15 after revealing the Monetary Policy Committee voted 5-3 to keep rates unchanged.

The Pound and financial markets were positioned for the composition to remain at 7-1, or even drop down to 8-0 owing to recent political turmoil.

Saunders and McCafferty joined Forbes in voting for a rate hike.

This is the closest the Bank has come to raising interest rates since 2007 and signals that policy-makers are growing impatient with the UK's elevated levels of inflation.

Economist Philip Shaw at Investec warns that on the back of these latest developments there could be an interest rate rise delivered as early as August with the Bank looking to scrap the 0.25% cut it enacted in 2016 following the EU referendum result.

Ahead of the event, money markets were pricing the first rise for 2020 and we had started the day reporting that one noted analyst actually saw an interest rate cut being delivered in 2018.

The consensus had clearly been caught off-guard by the outcome, and in the world of foreign exchange it is  how expectations are dealt with that really moves a currency.

"The more hawkish tone of the MPC appears to reflect some concern about inflation – which has accelerated faster than it expected over recent months and is now forecast to exceed 3% this year – as well as the strength of employment that is continuing to erode slack in the labour market," says Paul Hollingsworth, UK Economist at Capital Economics.

Clearly the Bank is not going to let rising inflation go unchecked and this realisation has helped the Pound with the currency moving sharply higher against its major competitors.

"Recently, MPC signalling has been on the hawkish side to encourage the market to dampen inflation pressures on its behalf. Nonetheless, this messaging has been completely ignored, with next to no rate hikes priced over the next year. As such, hawkish sentiment on the committee has advanced; given the precarious outlook for the domestic economy, the MPC cannot allow inflation to become entrenched,” says Alan Wilson, Senior Investment Manager of Active Fixed Income at State Street Global Advisors.

Positive Development for Sterling

This development suggests the UK could face an interest rate rise sooner than many had expected.

A rate hike is positive for Sterling in that higher interest rates attract foreign capital inflows.

Recall, interest rates settings at global central banks are the ultimate driver of currency value and jurisdictions with higher relative interest rates command capital inflows and therefore firmer currencies.

"We are now on a much more neutral footing toward sterling. The UK’s macro landscape remains rather mixed and political uncertainty remains a persistent concern. This is not without its potential silver linings, however, as the Brexit process now appears more open to interpretation. If confirmed, this reduces an important headwind for sterling," says Richard Kelly at TD Securities in London.

As can be expected the debateas to when the Bank will actually raise (or lower) interest rates will heat up going forward.

Kristin Forbes’ term finishes at the end of the month, potentially tipping the balance back towards the doves somewhat.

And despite only three mentions of the election in the minutes, Hollingsworth believes some members will surely want to wait to see how the current political situation is ultimately resolved and whether or not uncertainty has an impact on the economy.

These factors suggest that a rate hike within a matter of months remains unlikely.

"But with the economy having weathered political uncertainty relatively well in the recent past, and signs emerging that the Government may be about to ease back on austerity, today’s decision and minutes support our view that the first hike in interest rates will come much sooner than the April 2020 date implied by markets ahead of today’s meeting," says Hollingsworth.

A Cut in 2018?

However, not all are convinced that the Bank is necessarily heading towards a rate rise.

“The more hawkish tone resulted in a stronger pound and higher gilt yields, but we maintain our view that the cooling, consumer-reliant UK economy is setting the stage for unchanged rates through the next two years of Brexit negotiations – just have a look at retail sales which absolutely plunged in May for the second time in three months as rising inflation took its toll on purchasing power," says Mattias Bruér at SEB.

Others believe the Bank could actually cut interest rates in 2018; a move that will ensure an already under-pressure British Pound moves lower still and tests fresh multi-year lows.

In a mid-year briefing to clients, RBC Capital Markets have said they are expecting further easing from the UK’s central bank early next year amidst an environment of lacklustre economic growth.

The global financial services giant have also updated their forecasts and show the British Pound will struggle against the likes of the Dollar and Euro as a result.

UK Economic Growth Slowing Rapidly

The Bank of England sets policy according to economic growth with lower rates tending to reflect slower growth rates and higher rates coming in response to increasing economic activity and inflation,

The UK economy saw an even more pronounced slowdown in Q1 than previously estimated with GDP growth revised down to 0.2% from the earlier-reported 0.3% non-annualised increase.

“The slow start to 2017 reflected the smallest contribution from consumer spending in more than two years as household incomes were squeezed by rising inflation and slowing wage growth,” says Josh Nye, Economist at RBC Capital.

The latest employment and wages data out of the economy confirm this trend with real wages now in decline as inflation outstrips page hikes.

“That combination is set to remain a headwind in the coming quarters,” says Nye. “However, even with consumer-facing services industries seeing softer activity, purchasing managers’ index readings for the economy as a whole improved on balance in April and May.”

In fact Nye does see growth picking up slightly to 0.4% in Q2, although that would still be a sub-trend pace consistent with increasing slack in the economy.

RBC Capital think softer conditions argue for the Bank of England to hold monetary policy steady amid above-target inflation.

Others agree.

“There is limited room of changing monetary policy expectations to the benefit of the GBP. This is especially true as the BoE regards higher inflation as temporary while linking its policy stance to long-term and Brexit related uncertainty. Intact political uncertainty coupled with strongly capped central bank rate expectations should leave the GBP subject to downside risks,” says Manuel Oliveri at Credit Agricole in a note released ahead of the Bank of England's June 15 meeting.

Over the medium term, however, the UK's central bank sees inflation moderating at just above 2%.

And their forecast relies on a smooth Brexit process, an assumption Nye thinks is a bit optimistic particularly with political uncertainty rising in the wake of June’s general election.

“We look for the balance of above-target inflation and slowing growth to shift in favour of the latter, leading to further easing from the central bank early next year,” says Nye.

What Does this Mean for the Pound’s Outlook

RBC Capital believe the above scenario translates into a fall in the Pound to Dollar exchange rate of 1.19 in the third quarter of 2017, ahead of a decline to 1.15 by the end of the year.

By the middle of 2018 the exchange rate is seen back up to 1.22 amidst a broader recovery that could take it to 1.32 by the end of 2018.

No specific target on GBP/EUR is provided but a recent trade recommendation made by RBC Capital anticipated the Pound to Euro rate falling down to 1.1299 in the wake of the UK election.