Above: Mark Carney's press conference could give hints as to whether interest rates will rise again in May © Simon Dawson, Bloomberg, Bank of England
NatWest Markets - a division of RBS - say they expect the Bank of England's guidance to edge in a 'hawkish' direction which could help Pound Sterling head to fresh multi-month highs against the Euro and Dollar.
Foreign currency markets turn attention to Thursday's Bank of England monetary policy decision and inflation report for clues as to when they can expect the next interest rate moves.
We believe that Sterling has traded lower through the course of the week in anticipation of Thursday's event with traders looking to pare back on exposure to the currency incase of any disappointments i.e. should policy-makers try and cool expectations for an interest rate rise occuring anytime soon.
Markets currently price in a 50-55% chance that the Bank will raise rates in May; should the signal be that such expectations are too generous then Sterling might fall back. Analysts at UK high-street lender RBS' markets division - NatWest Markets, are however leaning on markets increasing their pricing for a May rate rise, which would help the Pound.
Interest rates are a key driver of Pound Sterling with the general rule of thumb being that higher interest rates make for a stronger currency as international investors send their money to the UK in order to profit on the improved yield that higher rates offer. We saw Sterling rally in the final quarter of 2017 thanks largely to the decision to raise interest rates at the November super-Thursday policy event.
NatWest Markets believe the next interest rate rise could occur as early as May but Governor Mark Carney and his team will want to wait for confirmation that a Brexit transitionary period has been agreed before making any changes to interest rate settings.
Prime Minister Theresa May and the EU are working towards agreeing on a transition period by end-March, so for now markets will have to focus on the subtleties of the Bank's thinking in anticipation of a more concerted push in policy at some point after March.
"The economy has been stable, data have on balance surprised to the positive side and inflation looks to have peaked. So there is scope for markets to continue to focus on the next iteration of BoE monetary policy," says Paul Robson a currency analyst with NatWest Markets.
Apparently the composition of Thursday's vote on whether or not to raise interest rates will be significant for the Pound as it could hint at whether their hunch for a May interest rate rise is correct - "we forecast 7-2, albeit not with any great conviction: probably Mr McCafferty, possibly Mr Saunders, registering dissenting votes for a rate hike," says Ross Walker, an economist with NatWest Markets.
While the vote will send a clear signal that markets will pick up on, what Governor Carney says in the ensuing press conference will will also be of note.
"We judge that mild hawkish risks pertain to the February 2018 Inflation Report. Less so in terms of the forecasts – where we expect to see relatively modest and to some extent offsetting revisions – than in the policy rhetoric," says Walker.
And what of the Pound?
Robson reckons any guidance shift from the Bank this week would create "even more clear water between those central banks that have started to tighten and those that are struggling even to pin down a potential start date for their next tightening cycle. In this respect, a guidance shift can play sterling positive next week if released."
This appears to be a pointed reference towards the European Central Bank which continues to print vast amounts of currency while not yet even talking about raising interest rates.
Indeed, "for the year as a whole, we expect Sterling to benefit from a large rise in real rates as inflation falls and nominal rates rise," says Robson who believes the Pound is currently below where it should be against the Euro.
While the expected fall in UK inflation this year will be slowed by higher oil prices, this will impact every economy, so it shouldn’t dilute the positive narrative expected from the Bank; "real rates are particularly important for Sterling because of the UK’s large current account deficit," adds Robson.
NatWest Markets are forecasting the Pound-to-Euro exchange rate to end the first quarter of 208 at 1.18; one of the more bullish Sterling forecasts out there. By mid-2018 they forecast the exchange rate to trade at 1.16, and down at 1.12 by year-end. So looking at the direction of their projections, it looks as though the Pound's best levels against the Euro will come earlier in the year.
The Pound-to-Dollar exchange rate is meanwhile forecast to trade at 1.35 by the end of the first quarter of 2018, 1.37 by mid-year and 1.39 by end-2018. This tells us that Sterling is looking expensive above 1.40 and that the recent pullback in the exchange rate is a valid one.
Yet, with their own expectations suggesting the Bank of England could help Sterling, their GBP/USD forecasts could be at risk of being too cautious.
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