Pound’s Break With Tradition Casts Doubt on Rate Hike Playbook

U.K. two-year yields climbed this week to the highest since the start of the pandemic, buoyed by traders’ ramped-up expectations for Bank of England rate hikes in 2022. Yet the pound fell to a year-to-date low and suffered the most volatility since March — a sign that soaring energy prices, falling business confidence and the end of the government’s furlough scheme outweigh any boost from a hawkish monetary policy outlook. 

It’s enough for Nomura International Plc strategists to turn bearish on the currency, prompting them to expect a dip to $1.3150 over the next month — a level last seen in December — from $1.3515 as of 12:03 p.m. in London. 

“The usual playbook of ‘BOE to raise rates equals strong pound’ isn’t going to happen,” Nomura’s Jordan Rochester said. “We’ve switched to being more focused on inflation expectations, and already there is a lot priced into the BOE.” 

The pound has fallen 2.3% over the past six months, underperforming all Group-of-10 peers except the Australian dollar. Options traders are losing confidence, with one-month risk reversals, a gauge of market positioning, near their most bearish in six months. Meanwhile, the cost of hedging turbulence in the pound over the next week is near the highest since March. 

‘Brexit Consequences’
Investors have been spooked by fresh complications arising from Brexit, rising wages and the possibility of an increase in national insurance tax next year. 

“It’s not just about the BOE, because if it were just about the BOE then we would be long,” said Anne Beaudu, a money manager at Amundi U.K. Ltd who is neutral on sterling. “It’s more about Brexit consequences.”

A flare-up in tensions over fishing this week has seen France accuse the U.K. of breaching the Brexit deal, which risks making market access for financial services even trickier. U.K. directors are the least optimistic about the economy since the height of the winter lockdown after confidence “fell off a cliff” in September. 

In a sign of the weakening pull of any signs of optimism in the U.K. economy, the pound only enjoyed a modest rebound on Thursday following stronger-than-expected GDP data.

Meanwhile, two-year gilt yields — among the most sensitive to rate-hike expectations — climbed this week to 0.47%, the highest since March 2020. This week, traders priced increases of as much as 65 basis points for 2022, which would take the BOE’s key rate to 0.75% by December of next year. 

“The prospect of BOE tightening could be seen as a policy mistake,” said Jane Foley, head of foreign-exchange strategy at Rabobank. “The weight of negative fundamentals in the U.K. has driven a wedge between the pound and rates.”