Pound Could Remain Volatile Against Dollar and Euro as New Interest Rate Consensus Develops

Sterling could be volatile until a new consensus on the future path of UK interest rates emerges.

The Pound could see increased volatility over major currencies over coming days and weeks as market expectations around future UK interest rates evolve and a new consensus emerges.

Sterling fell broadly against the G10 basket Thursday, shedding 1.09% and 1.29% against both its North American and European rivals, leaving the Pound-to-Dollar exchange rate quoted at 1.3109 and the Pound-to-Euro exchange rate marked at 1.1258.

Traders began dumping the British currency by the bucketload Thursday after the Bank of England prompted a “Sell the Fact” response to the UK’s first rate hike in a decade.

“It’s no surprise that the Bank of England has taken the historic decision to hike rates for the first time since the financial crisis. But the big news is that the Bank is no longer telling markets that their rate expectations are too low,” says James Smith, a developed markets economist at ING Group putting his finger on what he believes triggered the bearish reaction in Sterling.

GBP/USD at hourly intervals, capturing market reaction to Thursday's rate hike.

Markets had duly anticipated the BoE would add 25 basis points to the cash rate, taking it to 0.50% and were also pricing a further two hikes to come once into 2018 and beyond.

Crucially, for traders, the Bank of England omitted an earlier-clause, that said rates might need to rise “faster than the market expects” over the coming years, from its Thursday statement. This could suggest market pricing was either on-the-money or overly optimistic.

“We don’t rule out a second hike at some stage next year – it’s worth noting that the Bank appears comfortable with having one extra increase priced in for 2018. But that relies on the data, in particular on wage growth, improving and, more importantly, Brexit going smoothly,” Smith adds.

For the time being, bond and interest rate derivatives prices still suggest a further two hikes are likely before 2018 and 2019 are out, but economists and strategists are divided on whether or not they will actually materialise. Sterling could be volatile until a new consensus emerges.

GBP/EUR at hourly intervals, capturing market reaction to Thursday's rate hike.

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“We expect the UK central bank to hike at most one more time in the coming quarters, and as such we see GBP continuing to depreciate against both the euro and US$ next year, as Brexit and growth concerns continue to weigh on the minds of investors,” says Royce Mendes, an economist at CIBC Capital Markets.

Concerns over above target inflation and the potential for Brexit-related factors to push this higher in the coming months are credited with pushing the BoE over the edge and into the first move Thursday. But inflation is broadly expected to have topped out at a little more than 3% in October.

“The combination of inflation stabilising, real income growth improving and the likelihood of a transition deal leave us unconvinced that the rates market is accurately priced, “ warns Derek Halpenny, European head of global markets research at MUFG. “We currently see one further hike priced for next year and one further one beyond.”

The Monetary Policy Committee said in a statement accompanying Thursday’s decision that inflation is still expected to have peaked at a little over 3% in October and that, with a nudge from a higher bank rate, is likely to return toward target over the forecast horizon.

“Admittedly, it did not suggest that this is merely a “one and done”,” says Paul Hollingsworth, senior UK economist at Capital Economics. “However, the fact that inflation is expected to be only just above the MPC’s target at the end of the three-year forecast horizon seems to endorse the market's view that there will be only another two hikes over the same period.”