The pound has experienced a significant surge, driven by reduced expectations for an imminent Bank of England interest rate cut. Key indicators and market reactions have been pivotal in this development.
- The pound rose by 0.45% to $1.30, the highest since July 2023, after inflation data remained steady.
- Traders lowered the probability of an August 1 interest rate cut from 50% to 25%, reacting to persistent inflation.
- The yield on two-year gilts rose by 6.5 basis points to 4.01%, reflecting higher government borrowing costs.
- The UK economy saw its fastest growth rate in two years, complicating the case for monetary loosening.
Sterling increased by 0.45% to $1.30, its highest level since July 2023, following the release of official figures that showed persistent inflation in the services sector at 5.7% in June. Annual consumer price inflation held steady at 2%, meeting the Bank of England’s target, while other measures of inflation did not decline as economists had anticipated. This data led traders to reduce the probability of an August 1 interest rate cut from 50% to 25%, down from a 70% chance earlier this month.
Investors responded by buying the pound and selling UK government bonds, which are particularly sensitive to interest rate expectations. Consequently, the yield on two-year gilts rose by 6.5 basis points to 4.01%, and ten-year gilt yields increased to 4.08%, indicating higher government borrowing costs. In a higher interest rate environment, bond yields typically rise as prices fall, and currencies strengthen.
Despite the steady services inflation, the Office for National Statistics reported a 1.4% annual decline in goods prices, attributed to lower costs for items such as furniture, household goods, and clothing due to summer sales amid poor weather. Food price inflation also decreased significantly from over 17% the previous year to 1.4%, marking the lowest level since October 2021.
Economists suggest that Monetary Policy Committee (MPC) members will exercise greater caution in considering interest rate cuts, given that services inflation is 0.6 percentage points higher than the Bank’s forecasts. As noted by Sonali Punhani, UK economist at Bank of America, ‘Services inflation and wage growth remain high. The persistence of domestic inflation suggests that any rate-cutting cycle will likely be slow and shallow, with fewer cuts than our base case of two this year and four next year.’
Recent growth statistics have shown that the UK economy expanded at its fastest rate in two years, further complicating the argument for monetary policy easing. Economists predict that the headline inflation rate could rise from 2% in the coming months due to increasing energy prices, following a significant drop last year. The MPC will meet on August 1 to decide on interest rates and release updated economic growth and inflation forecasts.
Gabriella Dickens, an economist at Axa Investment Manager, mentioned that the nine-member MPC could still vote five to four in favour of reducing the base rate from 5.25% to 5% next month. For a shift to occur, support would be needed from Governor Andrew Bailey, his deputies Sarah Breeden and Clare Lombardelli, and the two MPC members who backed a rate cut in June, Sir Dave Ramsden and Swati Dhingra.
The Bank of England faces a crucial decision on interest rates amidst persistent inflation and strong economic growth, making an immediate rate cut less likely.
