Thursday, August 2, 2018

BoE hikes rates but Pound drops, what's going on here?

  • Dollar
  • Pound
  • Bank of England

Although it was considered a near certainty, markets have been eagerly awaiting today’s BoE decision. And as expected, the Bank of England raised interest rates by 25bps to reach 0.75%. This was BoE’s response to cool down inflation which surged after the Brexit referendum; the vote had sent the Pound plunging resulting in inflation remaining above the 2% target at 2.4%. This decision takes UK’s base interest rate to the highest level since March 2009.

However, the rate hike was one of the most controversial decisions in recent bank history, with opinions diverging on whether increasing borrowing costs is going to be a good idea moving forward. Nevertheless, the Monetary Policy Committee voted 9-0-0 in favor of raising which means that all nine members believed that it was a prudent move at this time.

Most analysts expected that Sterling would rise on the back of this news and would rally even more since the bank signaled a further increase in interest rates in the coming months if the economy performs as they expect. Albeit, it seems that investors disagree. The currency is under pressure and dropped to 1.3050.

Wondering why? In their statement the bank reported that “it recognizes that the economic outlook could be influenced significantly by the response of households, businesses and financial markets to developments related to the process of EU withdrawal." Brexit still represents the biggest uncertainty of the U.K. economy. Both Britain and the European Union are trying to reach an agreement by October ahead of the March 29th departure date.

However, there is still a lot of ground to be covered, with policymakers also preparing for a no-deal scenario. In this scenario, trading between the U.K. and Europe will become more expensive for businesses and would likely see a delay in goods reaching their destination. Even the London Stock Exchange said earlier today that it has put together a contingency plan for a no-deal eventuality. As such, investors have a valid reason not to react in a bullish manner to BoE's rate hike and instead look to take a defensive stance against the Pound.

So where does this leave us? We believe that the Pound will continue to the downside in the short term, as investors' worries combined with Dollar's strength do point lower. We could see a retest of the 1.30 floor but beyond that we hold a different view. We think that the Bank of England's intention to keep raising rates will prevail in the end and it will help the Pound recover in the weeks to come.

This combined with a potential slowdown in Dollar's rally during and after Q3 - as US the economy would find it hard to continue growing at its current pace - would allow room for a move higher in the Cable. So if you're a longer term investor this might be an opportunity to buy low. Having said that, please keep in mind that even though our scenario has its merits a breakdown in Brexit talks would render it useless so mind the risk you're willing to take if you buy Sterling right now.