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So should the Bank of England be thinking about raising rates?  This is the question that is going to be preoccupying sterling today and tomorrow as the Bank of England meets to discuss interest rates.

Guest post by  FxPro

Statistically, the risks are certainly higher  this month. During the MPC’s history, exactly half of rate changes have occurred in inflation report months, the next one being due next week.  This is the time when the Bank takes a step back and looks at the longer-term inflation outlook and risks, so it’s not that surprising that it can cause shifts in sentiment and views amongst the committee.  Furthermore, the fact that two members voted for a changes in rates at the January meeting has also been taken as a sign that sentiment may be shifting.

Indeed, this shift in sentiment has contributed to the marked shift in market expectations.  Looking at the forward market in overnight rates, there has been a shift  in pricing from around a 20% probability of a tightening of policy at the May meeting to now being fully priced for a 25bp tightening of rates by that time.  In terms of sterling’s sensitivity to rate expectations, this has certainly increased so far this year, the correlation between cable and two-year interest rate spreads (US and UK) having increased to around 0.55, from 0.40.

Even though surveys of economists are showing none  officially going for a rate hike, the market has certainly priced some risk of a move and, given this increased sensitivity to interest rate spreads, sterling will likely prove vulnerable to a no-change decision.  Thereafter, it is the inflation report next week that will serve to solidify or undermine market expectations for a tightening in May.  Sterling will need a relatively hawkish report to keep its place as one of the better-performing currencies of the year so far. The irony is that,  though  a stronger currency will undermine the Bank’s desire to see the UK economy shift towards a more investment and export-oriented economy, an ambition that has met with little success so far.

Simon Smith, Chief Economist, FxPro

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