- Pound to Euro rate is at 1.1567
- Pound to Dollar rate is at 1.2396
- Three scenarios in play for the Bank of England
- Two will result in GBP weakness
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The Bank of England is increasingly expected to announce a decision to keep interest rates unchanged later today in a decision that could prompt some interesting moves in the British Pound.
The Pound fell in the wake of the midweek release of UK inflation data that showed a broad-based cooling in inflationary pressures in the UK, prompting investors to scrub bets for further interest rate hikes.
Big names such as Goldman Sachs and Nomura informed clients they had shifted their expectations from another 25 basis point hike to no hike following the figures.
"A surprise pause would have a big impact on sterling," says Chris Turner, Global Head of Market Research at ING.
Turner's comment was made ahead of the inflation numbers and it now appears such a decision would no longer be a surprise to investors as money market pricing shows expectations for another rate hike are down to 50/50, from 80/20 ahead of the inflation release.
On balance, therefore, a pause might not be a massive negative for the Pound.
Instead, what matters will be the guidance accompanying such a pause.
Option 1: Hold, Resulting in Pound Weakness
Here, the Bank of England keeps interest rates unchanged and says it is happy to watch the incoming data when deciding on further rate hikes.
This would amount to a substantively 'dovish' outcome for the Pound given the Bank will have effectively materially raised the bar to further hikes.
It will allow the market to bring forward expectations for a rate cut in 2024, where there is ample bandwidth for movement.
In short, the Pound faces a great deal of downside on such an outcome given the scale of potential shifts.
"We continue to expect rate cuts only from the second half of 2024, though in the event that this new view proves correct and August was indeed the last hike we may have to bring forward our view of the first cut (currently November 2024) to an earlier meeting (August 2024, for example)," says George Buckley, an economist at Nomura.
Option 2: Hike, Resulting in Pound Weakness
Here a hike is delivered, but the Bank will almost certainly be required to offer guidance that a November rate hike is unlikely and that a peak has been achieved, in line with Governor Andrew Bailey's clear testimony to Parliament earlier this month.
As with option 1, the market would be able to bring forward its expectation for a rate cut, making this another soft outcome for the Pound.
"Inflation declined against expectations of a rise on the back of recently higher oil prices. Nevertheless, high wage growth will keep the Bank of England concerned about inflationary pressure. Therefore, we continue to expect a last 25 bps hike on Thursday," says David Alexander Meier, an analyst at Julius Baer.
Given recent growth data disappointments, Julius Baer sees no further hikes this year and adjusts its 3-month EUR/GBP forecast to 0.86 (from 0.85 previously). (GBP/EUR to 1.1627 from 1.1765).
Option 3: Skip and Promise a November Hike, Resulting in Pound Rebound
A more supportive outcome for the Pound would be if the Bank signals a pause but firmly commits to a November rate hike, arguing this allows them the chance to let incoming data reveal the impact of previous hikes while holding the insurance of another hike in the event of unwelcome data surprises.
Such a strategy delays the final hike and the hoisting of the 'job done' banner, in turn pushing back against that crucial pricing for a rate cut, in turn supporting the Pound.
For this to work, the market must be convinced by the Bank's guidance, a difficult task for a central bank that has often tended to lean towards dovish outcomes.
Above: "Very sharp repricing of BoE rate expectations in the market this morning: 45% chance of a pause tomorrow (20% on Tuesday), less than 20% chance of eventually going above 5.5% (42% yesterday). Purple line is yesterday's OIS curve" - Andy Bruce, Reuters. Note: Subsequent adjustments to this chart's capture showed odds were raised to 50%.
"Crucially, we don't think the hiking cycle is over just yet. A skip... doesn't necessarily mean that the MPC is out of the woods," says Sanjay Raja, Senior Economist at Deutsche Bank.
ING thinks the Bank will be concerned about placing excess pressure on mortgage holders via further rate hikes and will be eyeing "the Federal Reserve, which has succeeded in pushing back rate cut expectations with the so-called 'skip strategy'".
"By drawing out its tightening cycle by pausing at every other meeting, the Fed has managed to keep the conversation about how many hikes we have left, rather than how long it will take before we get rate cuts," explains James Smith, economist at ING.
"A similar strategy, whereby the BoE pauses in September but hints strongly that it could hike again in November, could be tempting for policymakers this week," he adds.
Ultimately, Few Supportive Outcomes for the Pound
Foreign exchange strategists are meanwhile expressing bearish sentiment on Pound Sterling as they see few supportive outcomes coming from the Bank of England.
"It is hard to see how the cyclical story can provide much support to GBP. We forecast GBP-USD falling to 1.18 over the next nine months and tactically favour selling GBP-AUD with a target at 1.8650," says Dominic Bunning, Head of European FX Research at HSBC.
ING's Turner says a "pause would have a big impact on sterling."
He warns that while the Bank may try to market a pause like a 'skip' - as deployed by the Federal Reserve - the market would doubt that it will be in a position to raise rates later in the year.
"The FX options market prices a 95bp GBP/USD range for the 24-hour event risk covering the Fed and BoE meetings this week. A BoE pause could well push cable below the May lows just above 1.2300," says Turner.
ING also anticipates the Pound to come under pressure against the Euro, despite the deterioration in sentiment towards the Eurozone's single currency over the recent weeks.
"Again this looks largely down to the greater downside for expected UK interest rates - a factor which should weigh on sterling into 2024. Our year-end 2023 EUR/GBP forecast remains 0.8800," says Turner.
EUR/GBP at 0.88 gives a Pound to Euro target at 1.1363.