Sterling nears two-week high as Bank of England rate path stays in focus

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Sterling nears two-week high

Highlights

Sterling rises to $1.3545, its highest since August 28, as soaring energy prices and Bank of England rate expectations drive UK inflation concerns.
Money markets show no rate hike expected at the Bank of England next week, but price in at least two, possibly three, increases by March 2024.
ING strategists estimate every $10 rise in Brent adds 15 basis points to UK two-year rates, yet caution that current market pricing of British rate hikes may be excessive.

Energy prices and rate expectations shape sterling

As reported by Reuters, sterling edges higher to $1.3545 on Wednesday, its strongest level since August 28, as investors weigh the effect of surging oil and gas prices on the UK inflation outlook and monetary policy.

Crude is now about 40% above its level before the war began at the end of February, while European natural gas prices are around three times higher. Britain is especially exposed because of its reliance on energy imports, and consumer inflation rises to 2.9% in July from June's 15-month low of 2.6%.

Money markets indicate traders do not expect the Bank of England to raise interest rates at next week's meeting, but they still price in at least two increases by next March, with a 40% chance of a third. By comparison, the rates market only expects the Federal Reserve to raise rates twice by that point.

BoE signals caution as analysts question market pricing

Despite market expectations, economists and analysts remain divided over how far the Bank of England will go, and Bailey pushes back against the idea that a rate increase is inevitable. Speaking before lawmakers in parliament on Tuesday, he says he wants to dispel the notion that the central bank has a secret and unconditional plan for where rates are heading.

Sterling is still one of the better-performing major currencies against the dollar this year, with a gain of 0.5%, compared with a 1% fall in the euro and a 2% decline in the yen. Much of that support comes from expectations that the Bank of England will eventually need to tighten policy, particularly as growth holds up.

ING strategists say higher energy prices help explain the market's reaction, estimating that since the start of the Iran war every $10 increase in Brent adds about 15 basis points to UK two-year rates, compared with 11 basis points for euro zone rates and 8 basis points for U.S. rates. But ING strategist Michiel Tukker says the British rate outlook reflected in markets looks overdone, while uncertainty over oil prices and fiscal risks ahead of next month's Autumn Budget complicates the outlook for sterling.

In our earlier article on sterling losing momentum as the Bank of England stayed cautious, we explained how the pound’s earlier outperformance was fading as investors anticipated relatively tighter policy from other major central banks. We also highlighted that uncertainty around the government’s upcoming budget could test market confidence in UK fiscal discipline, adding another layer of risk to the currency’s rate-sensitive outlook.

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