Sterling is at a crossroads this week as markets look ahead to the Bank of England interest rate decision on Thursday (May 11th). The pound has steadily strengthened since mid-January and enjoyed a further leg higher following Theresa May’s decision to call a snap election, but it now faces a stern test from a central bank that might follow up March’s hawkish surprise with a more dovish tilt.

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Cable was heavily bid up on Wednesday morning in leveraged trading and took a look at $1.30 briefly. GBPUSD is now trading firmly above its 200-day moving average and seems to preparing itself for an ascent on the $1.30 peak. Should it scale this level there are some short-term momentum indicators that suggest it could go higher.  Many banks are starting to forecast renewed sterling strength, arguing that worst of Brexit has already been priced in. 

Can the pound find its feet above $1.30? The sunlit uplands of the mid-$1.30s might await if it does, as a decisive move could deliver significant upside potential.

A key signal of short-term momentum is the so-called ‘golden cross’, when the 50-day moving average cuts up through the 200-day average. From a technical standpoint this is a strong bullish signal and the two lines are converging at present. Moreover we may also see the 200-day moving average finally begin to turn higher after heading south since September 2014. But can the pound really march higher, or has there been too much made of sterling’s gains of late?

Providing sterling holds gains just shy of $1.30 the 50-day SMA is looking ready to climb higher as we head towards the May 11th meeting, as some of the worst of the mid-March weakness in Cable exits the calculation in the coming days. That should drive the 50-day even closer to the 200-day level, meaning it shouldn’t take too much of an upswing to encourage further momentum north.

GBPUSD_May8th_SMAs

The Bank of England meeting therefore comes at an important moment for cable and the tone of the Monetary Policy Committee (MPC) is likely to be key. Although the Bank is not expected to change rates, it has plenty of room to sound more or less hawkish than it did at the last meeting in March.

At that meeting the Bank delivered a ‘hawkish surprise’ as one of the nine MPC members voted to raise interest rates. Kristin Forbes, who leaves this summer, is a noted hawk but there was some sense from the minutes that she might be able to persuade other policymakers to call for tightening. If one or two additional members vote for a hike at the May meeting the pound could be set for the kind of jolt that sends above $1.30. (note we have just 8 rate setters this week due to the resignation of Charlotte Hogg). Michael Saunders is one on the MPC who has recently hinted at voting for a hike.

 Some are not that far away from hiking. Minutes from the meeting showed “…some members noted that it would take relatively little further upside news on the prospects for activity or inflation for them to consider that a more immediate reduction in policy support might be warranted”. There does seem to be a desire to normalise policy but it will take more than inflation at 2.3% to trigger a hike if growth remains soggy.

Does the data support a hike or, more pertinently, for some more members to call for one? CPI rose to 1.8% in January and since the last BoE meeting we’ve this rise to 2.3%, where it has held for two months. This is noteworthy for two reasons. First it is above the Bank’s target, which ought normally to be a signal that rates may rise soon. Second, having accelerated in recent months, price growth has now stabilised and the threat of runaway inflation seems to have abated, although economists still expect it to climb further. The Bank may decide that inflation may not rise as fast as previously thought, which ought to further dampen calls to raise rates soon.

Growth, on the other hand, has failed to match inflation. GDP growth sank to just 0.3% in Q1 from 0.7% in the preceding quarter. Annual growth came in at 2.1%, just shy of forecasts. The bank may well scale back its growth forecasts for the year. The data is not particularly supportive of a change in policy, being too lacklustre to warrant tightening but certainly not so weak that further accommodation is required. The Bank is therefore likely to stick to its view that “there are risks in both directions”.

Inflation pressures notwithstanding, there seems very little chance that the MPC will vote to raise rates. The only real reason to raise rates is the inflationary pressure but this seems to be a) slowing, b) transitory and c) down entirely to sterling weakness and not due to aggregate demand growth.

Indeed the BoE noted in March that the projected overshoot ‘entirely reflects’ the expected effects of the drop in sterling.  Pay growth is subdued, while measures of inflation expectations are not that high.

Raising rates purely to outset transitory inflation feeding through from sterling weakness is neither what the Bank wants to do nor should do, as it would come at the cost of higher unemployment and weaker income growth.

Therefore it seems highly unlikely that the MPC will vote to raise rates, however sterling bulls will be looking for additional hawkish noises from policymakers to drive the pound higher. They may be disappointed.

The big risk factor that the Bank cannot ignore is Brexit. While the UK economy has proved resilient since the EU referendum last June, there are signs of cracks appearing. Given the uncertainty the Bank would likely judge it as being undesirable to embark on tightening when it could choke the life out of the economy.

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