Dovish Bank of England vote, inflation warning hurt sterling

By: | Published: August 7, 2015 8:22 AM

Sterling fell sharply on Thursday after just one Bank of England policymaker voted for higher interest rates at a meeting where the bank warned the strong currency and weak energy prices would keep inflation subdued well into next year.

Sterling fell sharply on Thursday after just one Bank of England policymaker voted for higher interest rates at a meeting where the bank warned the strong currency and weak energy prices would keep inflation subdued well into next year.

Many in the market had speculated that at least two members of the bank’s policy committee would vote for a rate hike, so traders pushed back expectations of the first move to February or March 2016 from closer to the turn of the year. <0#FSS:>

BoE Governor Mark Carney told a press conference that despite sterling’s persistent rise – up 20 percent on a trade-weighted basis since March 2013 – the case for a rate hike was very much intact. Nevertheless, any lingering expectations of a first rate hike occurring this year disappeared, driving investors to sell the currency.

Sterling fell to a low of $1.5481, having traded at $1.5600 beforehand, before recovering to trade at $1.5525, still down 0.5 percent on the day. The euro jumped 0.7 percent to 70.43 pence.

British government bond yields fell, while stocks recovered from earlier losses as UK property and house builder shares rose.

“The key is the 8-1 split. That was the headline-grabber that took sterling lower across the board. The market was somewhat bulled up for at least 7-2,” said Neil Jones, head of FX hedge fund sales at Mizuho, adding that the bank’s medium term inflation forecast was disappointing.

Despite subdued inflationary pressures, sterling has been underpinned in recent weeks by robust economic data, with British consumer demand holding up, wages rising and the pace of growth accelerating in the second quarter.

Governor Carney had earlier indicated a decision on rates will come around the turn of the year.

Markets have ramped up expectations of a rise in rates several times in the past three years only to be disappointed. Nevertheless, with the U.S. Federal Reserve inching towards a hike in September, investors appear more confident this time.

As such, speculation over a UK rate increase has pushed up the value of sterling, which on Wednesday hit its highest level against a basket of currencies in more than seven years, potentially making it harder for the BoE to press ahead with an actual hike.

A higher currency lowers the cost of imported inflation, keeping a lid on price pressures. British consumer price index fell to zero in June from 0.1 percent in May, with downward pressure on inflation likely to persist for some months as crude oil prices remain soft.

“With inflation likely to dip again before it returns to 2 percent, this is a very difficult backdrop against which to hike rates,” said Andrew Wilson, EMEA CEO of Goldman Sachs Asset Management.

SENSITIVE TO CURRENCY

The BoE’s sensitivity to a rising currency and its impact is not something unique. Earlier this year, as the U.S. dollar hit decade highs on expectations that the Fed could start raising rates in June, a slew of policymakers warned about its impact in U.S. growth and inflation.

“The BoE clearly isn’t as confident as it was about the strength of the recovery in the near term. The MPC seems to agree that now is not the time to throw caution to the wind, with an economy that has spluttered along for much of the post-crisis period,” said Lucy O’Carroll, chief economist at Aberdeen Asset Management.

“Rate rises remain on the agenda for early 2016. The exact timing hinges on the strength of the numbers in months ahead.”

Gilt yields fell sharply, with the 10-year down around 4 basis points to 1.94 percent. The premium that 10-year gilts offer over the equivalent German Bund narrowed around 3 basis points to 122 basis points.

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