Sterling steadies as BoE returns to New Normal

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By :  ,  Financial Analyst

Pound firms above $1.40

The key takeaway from the Bank of England’s information dump on Thursday, confirmed by Governor Mark Carney soon afterwards, was that policymakers’ tolerance of inflation well above target has ended. Recent speculation that this would happen was a key driver of sterling’s revival and breach of $1.40, so confirmation has recharged the pound. Sterling against the dollar rose above the marker for the first time since severe volatility returned to global markets last week. This matters because as that volatility subsided, it was not certain whether sterling would maintain its healthiest levels since the referendum under less charged conditions. To be sure, sterling uncertainty remains, not least given the relapse of the dollar as its recent revival threatens to fade. But as UK monetary policy catches up with a stronger-than-forecast economy, probabilities for a sustained sterling recovery are rising.

Hints tempered, but not much

The Bank did temper hints of tightening with cautions that are typical with Britain on track to leave the European Union in 2019. For instance Carney and Deputy Governor Ben Broadbent were keen to stem potential misinterpretation of productivity data that appeared to show improvement after a long spell of stagnation. In fact, a drop in third quarter readings was flattering more recent rates, and the long-term trend was largely intact, they noted. Additionally, the Bank said business investment rates were still restrained by “Brexit related uncertainties”, bringing the weakest investment recovery for over 50 years.

“Squeezed”, but still spending

However, policymakers seemed more inclined to use such nuances to hone a clear message that rates would rise sooner and further than it said late last year. In other words, the cautions were not factors that could conceivably delay a steeper gradient for rates. The Bank was now more sanguine about other aspects of the economy it had previously said could argue against tightening. For instance, elevated household spending by “squeezed” consumers was being driven by income, not debt, said Carney in Thursday’s press conference, signalling that earlier worries about high consumer debt are falling away amongst policymakers. Furthermore, modest growth compared to historical averages was not another reason to stand pat. It was more important that such growth allowed inflationary pressures to build, “and there may need to be adjustments to interest rates”, said Carney. The MPC also communicated low concern about recent market volatility, seeing it as “healthier” for markets to have “two-way risk around prices”. Again, this suggests policymakers were relatively relaxed about price moves and trends on assets like shares and sterling and the potential impact of a rate rise on these in the fairly near term.

Expect stocks to catch-up with the pound

Whilst Governor Carney was reluctant to pinpoint a specific date for the next rate rise, the MPC’s May meeting, when it will next update forecasts, seems consistent with signals the BoE offered on Thursday. The move, when it comes, will see the Bank revert to a more ‘normal’ stance on inflation even though times are far from what were previously recognised as normal. Even so, policy normalisation should enable sterling to continue leading normalisation in markets. In the medium term, this may not be such good news for shares. Both the FTSE 100 and the mid-cap FTSE 250 took Thursday’s notice that rates were on the up as negative and traded lower. However, further out, we expect recent evidence of a weakened pound/stocks correlation to become clearer. This should enable equities to participate in the return to the ‘new normal’ for UK markets as well.

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