Wednesday, 11 May 2011

Pound Soars After BOE Signals Potential Rate Increase

Sterling was up across the board after the Bank of England increased its inflation forecasts and signaled it will begin tightening monetary policy vis-à-vis higher interest rates. This should keep Sterling as a bid in the near term versus both the dollar and the euro.

The quarterly inflation report from the BOE began the process of mapping out future policy moves to fight rising inflationary pressures. The central bank said inflation will be “markedly higher” due to rising energy prices while growth should begin to slow. Inflation expectations are forecasted to remain above the 2% target set by the BOE for the next two years.

To fight rising inflationary pressures which currently stand at 4% from the last reading in March, the BOE anticipates raising the benchmark interest 25 bps in the third quarter this year with an additional 25 bps hike in each quarter in 2012. At this pace the benchmark rate would rise to 1.75% by the end of 2012 from the all-time low and current rate of 0.5%. Despite the upcoming interest rate hikes, the rate of inflation could reach 5% this year.

Growth rates should also weaken more than the BOE previously predicted as the recent belt tightening by the British government will weigh on GDP. Combined with higher energy costs, the BOE says growth risks are “skewed to the downside”.

The market took the announcement as an opportunity to place a bid on Sterling and the pound soared across the board with the GBP/USD rising to 1.6513 from 1.6369 and the EUR/GBP falling sharply to 0.8691 from 0.8795.

While the announcement was not shocking to the market as most traders had at least priced in 25 bps of tightening this year, Sterling should remain supported in the near term despite the risks to growth. Markets continue to focus on yield differentials and the Fed is not expected to adjust US rates until mid-2012.

Initial resistance for the GBP/USD is located at the April 21st high of 1.6600 followed by the April high of 1.6745. For the EUR/GBP, today's low coincides with the previous trend from the 2008 high which has turned into support. A breach here would test 0.8670 followed by 0.8350.