August 7, 2013 / 11:34 AM / 6 years ago

Markets bring forward UK rate hike expectations after Bank of England

LONDON, Aug 7 (Reuters) - The Bank of England’s new guidance on interest rates caused investors to bring forward expectations for when interest rates would rise from a record low, pushing sterling to a one-and-a-half-month high.

In its quarterly Inflation Report, the first presented by new governor Mark Carney, the bank said future interest rate rises would not happen until unemployment fell to 7 percent, something unlikely for three years.

This initially caused sterling to fall and interest rate futures to rally. However, after a string of recent strong UK data, many in the market concluded that unemployment may come down to that level faster than the bank’s three-year horizon.

Analysts and traders said some had expected that if the Bank of England tied interest rate rises to unemployment that the threshold would be lower, at around 6.5 percent.

After the bank’s report, overnight indexed swaps priced in a 90 percent chance of a rate hike from the current 0.5 percent in three years’ time, and some chance of this happening as early as 2015. Within four years they priced in a increased probability of two 25 basis point rate hikes.

Sterling rose to $1.5493, its strongest since late June, well above a low of $1.5205 hit soon after the Bank of England’s report was released.

“The threshold target for unemployment was higher than the market was expecting and the market’s perception was that if the economy recovers then rates might rise sooner,” said Paul Robson, currency strategist at RBS.

He added that the pound could now start to rise strongly in response to strong UK economic data, especially jobs data.

“Sterling will now become more sensitive to activity data than simply to inflation data, as it was in the past.”

The UK unemployment rate was at 7.8 percent in June. This means it is closer to the Bank of England’s 7.0 percent threshold than the U.S. unemployment rate — which stands at 7.4 percent — is to the Federal Reserve’s 6.5 percent threshold.

Short sterling futures enjoyed only a brief rally and by midsession were flat across most of the strip, and lower in contracts from 2015 onwards.

Gilt futures also backtracked to stand 40 ticks lower on the day, underperforming Bunds. In the cash market, gilt yields rose three to five basis points across the curve. The yield spread between 10-yr gilts and Bunds rose to a 3-year high above 82 basis points.

The euro was down 0.8 percent at 85.98 pence, having hit a two-week low of 85.85 pence. A fall below 85.82 pence would take the euro to its lowest in four weeks.

Analysts also said rates could rise sooner if a recovering economy causes higher inflation.

“The BoE’s pre-commitment to keeping rates at a record low is not as conclusive as it first appeared,” said Lena Komileva, director of G+ Economics.

“What was unexpected (in the Inflation Report) were the get-out clauses. This has injected some volatility into the back-end of the gilts curve as well as sterling.”

The bank said it would consider raising rates if their low level posed a threat to financial stability, if the public’s medium-term inflation expectations rose dangerously or if it forecast inflation in 18-24 months at 2.5 percent or higher.

Concerns about the risk of an earlier interest rate rise caused the UK’s FTSE 100 Index to fall 0.9 percent.

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