Sterling falls against dollar and euro on 'dovish' UK rate hike

The Bank of England's dovish stance contrasted with the ECB, which also raised rates by 50 basis points, but signalled further increases ahead to combat rising prices

The Bank of England has raised interest rates by 50 basis points. 

Sterling extended losses and UK government bonds rallied after the Bank of England slowed the pace of monetary tightening, which investors took as a sign that interest rates eventually may peak at a lower level than expected.

The currency fell as much as 1.1% against the dollar to $1.228 after the Bank of England raised interest rates by 50 basis points. 

Analysts noted however, that two members of the Monetary Policy Committee had voted against the hike, preferring to keep rates unchanged following an unprecedented 75-basis point hike in November.

As a result, the nine-member committee was split three ways on the decision, as officials tried to balance the risk of inflation getting entrenched against squeezing too hard on growth, with the UK economy entering a recession.

“The voting split suggests that this is a dovish rate hike,” said Valentin Marinov, FX strategist at Credit Agricole.

The Bank of England's dovish stance contrasted with the European Central Bank, which also raised rates by 50 basis points, but signalled further increases ahead to combat rising prices, pushing the euro more than 1% higher versus the pound to a three-week high. 

The Bank of England's move comes a day after the US Federal Reserve raised rates by a half point and signaled borrowing costs will probably head higher than investors expect next year.

Economists expect the UK to be stuck in a recession for most of 2023, which may help cool inflation pressures. This in turn could mean that Bank of England tightening reaches a lower level of terminal rates than the market has priced in, said Jeremy Stretch at CIBC.

“It’s still the case that the macro backdrop in the UK looks weaker than elsewhere,” said Mr Stretch, who expects rates to peak “just shy” of 4% next year.

“If the BOE are not going to be quite as aggressive in terms of terminal rates compared to where the market is assuming, then that leaves sterling looking potentially vulnerable, if not against the dollar, then certainly against the high-beta currencies,” he said, adding he saw room for the pound to fall further towards $1.225 in the near term.

The Bank of England may find it hard to sustain restrictive policy for a prolonged period, said Toronto-Dominion Bank rates strategist Pooja Kumra.

The Bank of England has been raising rates since December 2021 to tame soaring inflation, which hit a 41-year high above 11% in October. But consumer-price growth cooled more than expected in November, raising the possibility that the worst of the cost-of-living squeeze is over.

Some in the market were unconvinced that inflationary pressures were on the wane, given a tight labour market, which may keep upward pressure on wages.

“The recent fall in inflation no doubt played a role in the Bank of England feeling ready to reduce the pace of tightening to a 50 basis-point hike at its meeting today,” said Karen Ward, chief market strategist for Europe at JP Morgan Asset Management.

“However we are not convinced that the UK’s inflation troubles are clearly behind us, and therefore suspect the BOE is still some way away from ‘peak rates’,” she added. 

Bloomberg