BoE Preview: GBP Reaction

The first back-to-back UK rate rise since 2004? Will British central bankers surprise the markets again or continue the expected path to normalising interest rates?

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A sure thing?

In the latest survey of economists done by Bloomberg, all agreed that the Bank of England would raise rates by 25 basis points at the next meeting. This would take the policy from the current 0.25% to 0.50%. There is even outside speculation that the rate could be hiked by 50 basis points (the equivalent of "two rate hikes").

Since it seems a rate hike is as close to a ‘sure thing’ that you’ll get, analysts are looking beyond the meeting since the hike is already priced in.

The focus is now on Governor Bailey's post-rate-decision comments and changes to the BoE's inflation outlook. CPI inflation reached a 30-year high of 5.4% in December. This has elevated Q2 expectations to inflation rising above 6%. There is also a universal agreement that the BoE will raise its estimates for inflation for next year. By how much would likely be parsed by the market, potentially adjusting the expected hiking cycle.

Where the differences lie

As is often the case, markets have a more radical monetary policy outlook than economists. The average economist sees the BoE's target rate ending the year at 0.75%. That would be two rate hikes over the year, including the one tomorrow.

The market, however, has priced in rates rising to 1.0% - that is, three rate hikes - by June. That would be once every other month and the most aggressive cycle in history. Figuring out which one is right might be the key to understanding the market reaction.

How will markets react?

If the BoE doesn't substantially raise their interest rate outlook, the market could interpret that as fewer future hikes. That would likely be seen as a dovish scenario, and we could see the cable underperforming despite the bank hiking rates. Although unlikely, a surprise decision not to raise interest rates would not be unprecedented (it happened in November!) and could aggravate downside risks.

If the BoE expects inflation to be above its target rate by the end of the year, the market could interpret that as an admission that the bank's aggressiveness is appropriate. However, the market prices that in already. So, arguably the bar has been set higher by the markets for a ‘hawkish surprise’.

What's next for cable?

GBP/USD was up nearly 4% on January 13 from its price during the bank's last meeting. It has dropped 2.86% after peaking at the 200-day average near $1.3750 but recovered half of that this week alone. The 50-DMA and 1.335 support has held firm as we run-up to the meeting.

A hawkish BOE could set up GBP/USD to rise back over its long term descending trendline, while a dovish BOE could see the falling trendline and the 200 DMA again cap the upside and see another test of 1.335.

Source: Spreadex Trading Platform

Key Takeaways

The BoE will most probably deliver a hike, but the uncertainty arises from the aggressiveness of the coming tightening of the cycle. Investors must focus on the bank's inflation expectations and where officials see it pan out by year's end.

Let’s not forget that the market has already priced in more than one hike so more might be needed to stop any upside from being short-lived.