Pound Sterling Outlook Upgraded as Bank of England Tipped to Raise Interest Rates in Early 2018

Bank of England interest rates

Pound to Dollar exchange rate forecasts are given a sharp upgrade by Capital Economics while Pound to Euro exchange rate forecasts remain unchanged on a stronger single currency

UK interest rates will rise sooner and more quickly than is generally anticipated is the message from independent research house Capital Economics who say the Bank of England will be unable to ignore the economy’s continued resilience for much longer.

An interest rate rise in the next 12 months will have important implications for the British Pound which ultimately tracks the yield offered on debt in the UK.

Higher interest rates = higher yields relative to other nations = a higher Pound.

If the majority of the market were to converge on Capital Economics’ view then we could well see Sterling move higher over coming weeks and months.

“While the outlook for UK monetary policy is highly uncertain, the economy’s continued resilience suggests that interest rates will rise sooner and more quickly than is generally anticipated,” says Jonathan Loynes, Chief Economist at Capital Economics in London.

Uncertainty around such a call is of course understandable.

Why Now is NOT the Time to Raise Interest Rates

Capital Economics have taken into account the countervailing argument against an interest rate rise in the near future.

While the economy has proved resilient to the vote for Brexit, the outlook is very uncertain and there are signs that growth has started to slow as higher inflation pinches households’ spending power.

We have seen a slowdown in the tenor of PMI data over recent months alongside a sharp quarterly drop in retail sales which suggest the all-important UK consumer is reining in spending in the face of rising prices.

“And Brexit-related uncertainty could yet have a bigger negative impact,” acknowledges Loynes in a note to clients dated April 5.

Capital Economics also note that wage growth and inflation expectations remain low and that there is a danger that tighter monetary policy would force the Pound higher and hence bring the signs of a long-awaited re-balancing of the economy away from consumers and towards exports to a halt.

Why Now is the Time to Raise Interest Rates

But for Loynes and his research team that UK economic growth might slow over coming quarters is by no means justification enough to warrant emergency settings at the Bank of England.

In short - current interest rates are not appropriate for a country moving along at ~2% annualised growth.

“The current unprecedentedly loose policy stance was initiated to prevent the 2008 recession from turning into a 1930s-style depression and enhanced to mitigate the expected damaging impact of the vote for Brexit. Yet with depression risks having long receded and the worst Brexit fears proving unfounded (and not just because of the policy response) there is a strong case for removing some of the emergency stimulus.

This argument echoes that of Bank of England MPC member Kristin Forbes who in March voted for an interest rate rise.

In a speech made prior to her vote she argued that rates should be eased higher off record-low levels in order to avoid the kind of shock a rapid series of rate rises might prompt.

Capital Economics argue that easing back from emergency settings would still leave monetary policy highly supportive, while the Pound will not be given enough fodder to rise to levels that would endanger the UK’s export sector.

“And there are additional arguments too that raising interest rates would relieve some of the pressure on long-suffering savers, help to prevent a major credit bubble and replenish the policy ammunition available to the Monetary Policy Committee (MPC) should the economy enter another downturn,” says Loynes.

That these opposing arguments are finely balanced is evidenced both by the growing signs of divisions within the MPC itself and the regular swings in market expectations for interest rates.

When Will the Bank Raise Interest Rates Then?

Money markets show the implied timing of the first 25bps interest rate hike has fluctuated between the middle of next year and mid-2022.

Capital Economics interest rate rises

Capital Economics say that if they are proved right in expecting the economy to remain pretty robust, then the justification for maintaining the current policy stance will gradually weaken.

“Given this, our central forecast is now for Bank Rate to start to rise in the second quarter of next year and then climb to about 1.25% by the end of 2019,” says Loynes.

This would be an earlier and faster rise profile than the markets and most forecasters are anticipating.

“We would stress that such a path for interest rates would primarily reflect a fairly healthy economy rather than serious inflation worries and would still leave rates at historically exceptionally low levels for a long time yet,” says Loynes.

Understandably this view has implications for the Pound.

Pound Forecasts: Gains Against the Dollar, but not the Euro

Based on an expectation that the Bank will start raising interest rates in 2018 Capital Economics have advised they see a higher profile for the UK currency.

Capital Economics’ foreign exchange analyst John Higgins says he believes the US Dollar will still rise against Sterling through 2017 and will end the year at 1.20.

Their Pound to Euro exchange rate forecast for the end of 2017 is at 1.2048.

Next year, though, they expect the Dollar to fall against the Euro and Sterling.

Capital Economics have cut their end-2017 forecast for the 10-year yield to 1.5% from 1.75% but project that it will climb to 2.5% in 2018, above their old forecast of 2.0% as the Bank of England raises rates sooner, and by more, than they had previously envisaged.

Their new end-2018 projections are for the Pound to Dollar exchange rate to be at 1.30, up from a previous 1.20.

The end-2018 Pound to Euro forecast is at 1.18 which suggests the recovery in Sterling is more or less neutralised by the recovery in the Euro against the Dollar.

As we move into 2019 Capital Economics think the Euro and Sterling will climb further against the Dollar to $1.15/€ and $1.35/£.

The GBP/EUR exchange rate is forecast at 1.1740.

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Vlighe Pushes Back Against Raising Rates

While Capital Economics see the case growing for higher rates sooner than markets are expecting it must be recognised that members of the Bank's MPC remain sharply divided on the matter.

Mid-week MPC member Gertjan Vlieghe gave a speech at the Bloomberg headquarters in London and said a continuation of the cautious rate strategy is currently warranted.

He is worried that the U.K. consumer slowdown will intensify and felt that a premature rate hike is worse than a late one. 

"With that in mind, Sterling traders completely shrugged off his warnings and chose instead to see relief in his view that inflation drives policy so price pressures beyond FX could cause a rate hike," notes Kathy Lien, Director at BK Asset Management.

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