Bank of England did not comment on rate path
As expected, the Bank of England (BoE) raised the Bank Rate by 25bp from 0.25% to 0.50% with the vote count 7-2 (Sir David Ramsden and Sir Jon Cunliffe dissented) in line with our expectation but against the consensus view of a 6-3 vote count. It is likely this explains why EUR/GBP moved lower initially. However, UK yields declined 6-9bp across the 2-10Y curve and EUR/GBP ended higher, as the Bank of England did not comment on current market pricing (two hikes over three years, this is also what the BoE’s projections are based on), meaning the BoE keeps its flexibility. In addition, the BoE said it will ‘monitor closely’ incoming data ‘including the impact of today’s increase in Bank Rate’. During the press conference, Mark Carney said the rate hike is just a ‘small adjustment’ and that the BoE has ‘stretched the horizon of which CPI inflation should return to 2% target due to unusual circumstances’ (Brexit). Still, Carney noted that inflation is expected to remain slightly above 2% even assuming the two hikes over three years currently priced in the market. Overall, the signal is neutral, which was more dovish than the market had expected, in line with our expectation. Another important thing is that the BoE says that potential growth is 1.5% y/y, so as long as GDP grows by above 0.3% q/q, then the economy will continue running hotter.
We still believe the BoE will stay on hold next year and not hike again before 2019, so this is more about taking back the emergency cut from August 2016 just after the Brexit vote. We think it is likely the BoE is too optimistic on wage growth and we believe the BoE does not want to tighten monetary policy too much relative to the ECB. The ECB has just extended QE by nine months, meaning it is unlikely to raise rates before 2019. Markets currently price in a Fed-like hiking cycle with one hike a year.
Relative rates, growth and Brexit uncertainty set to support EUR/GBP near term
EUR/GBP increased following the rate hike announcement in line with our expectation as the BoE refrained from commenting on future rate hikes. With the next rate hike priced by November 2018, we see market pricing as slightly on the hawkish side in the sense that it is more likely that rate hike expectations for 2018 will be lowered in coming months than that more rate hikes in 2018 are priced in. Overall, we still expect EUR/GBP to trade within the 0.8650-0.9000 range in coming months, with Brexit uncertainty remaining a source of volatility. In the near term, we expect relative rates, growth and Brexit uncertainty to be EUR/GBP positive and we still expect the cross to test the high end of the range.
Longer term, Brexit negotiations remain the key determinant for GBP and we still see potential for a further decline in EUR/GBP driven by possible clarification on Brexit negotiations and valuations. However, with the ECB moving towards an exit as well and as relative growth is set to remain EUR/GBP positive, we see only modest downside potential in the year ahead. We target 0.87 in 6M and 0.86 in 12M.
