BOE’s surprise rate hike sends the pound zooming

The Bank of England (BOE) and the pound sterling dominated the currency market action last week. The British central bank, to the market’s surprise, raised its monetary policy rate by 0.25% to 4.75% on August 3. Helped by the BOE rate action, the pound sterling rallied across the board, posting particularly strong weekly gains against the US dollar.

The greenback, which seems to be in the middle-of-a-down phase, remained mired in the prevailing confusion over the US Federal Reserve’s rate decision on August 8. The US employment figures titled the balance in favour of a pause, pulling down the greenback in the process. A rate hike by the European Central Bank (ECB) on Thursday with indications that more rate hikes would follow this year, added to the greenback’s woes.

The BOE’s first rate hike in two years was prompted by consumer price inflation rising to 2.5%, much above the Bank’s target level of 2%, along with signs of buoyant growth which would exert upward pressure on inflation. In fact, given the recent spate of robust UK economic data, a 20% chance of rate hike was priced in and now the money market is pricing in another hike before the end of this year.

The ECB rate hike to 3% was widely expected, but the ECB president Trichet’s post-policy meeting statement suggested that there were more rate hikes possible, than priced in by the market. At present, there is about an 80% chance priced in for a 0.25% hike in October and 67% chance of a hike in December.

In contrast, the market reduced the probability of an August 8 rate hike by the Fed below 15%, after yet another benign US employment report. The report showed that, in July, payrolls in the manufacturing and services sectors rose by smaller-than-expected 113,000. And on top of that unemployment rate rose to 4.8% from 4.6%. Average hourly earnings, however, were still at the high end of expectations.

The US data released earlier in the week, along with the BOE rate hike, had raised the chances of a rate hike. An indicator of the manufacturing sector activity, the ISM index, printed stronger than expected, thus alleviating the growth slowdown fears. And, the Fed’s preferred inflation measure, the core Personal Consumption Expenditure deflator, rose 2.4% in June. This was well above the 2% upper limit of the Fed’s tolerance limit. The greenback, however, did not bounce much on these numbers.

News on the ongoing central bank foreign exchange reserve diversification also resurfaced last week. Bank of Italy, in a report, revealed that it cut US dollar-denominated reserve holdings from 84% at end-2004 to 63% by end-2005. The Bank shifted reserves to the pound instead, from zero to 24%. Other central banks around the world have also been reducing their US dollar holdings. In Europe, Sweden and Russia have preceded Italy. Such reserve diversification is clearly negative for the greenback. 

In the local inter-bank market, rupee had a stable week. The Indian unit opened the week on a stronger note helped by a weak greenback overseas and the upgrade of India’s credit rating to “investment grade” by the international rating agency Fitch. However, rupee slipped on Wednesday on the back of dollar demand from oil companies at lower rupee-dollar rate levels. Banks also bought dollars ahead of critical US data releases and noting an oil price flare-up towards $75 per barrel again. Over the next two days, the rupee recovered value as the dollar slipped sharply overseas and dollar demand subsided.

Equity market conditions last week were also supportive for the rupee. The BSE Sensex rose by 1.7% over the week and foreign institutional investors were net buyers of Indian equities and bonds to the tune of $132.3 million. Overall, the rupee traded in the range of 46.45 - 46.78 against the dollar and gained 0.3% in value. The Indian unit, however, slipped by 0.6% against the euro.

This week, the Fed monetary policy committee’s rate decision on Tuesday is the most crucial event for the market. A rate hike would help the US dollar gain value, given that the market sees slim chances of such an action. But with the Fed likely to pause its rate hike cycle after that for an extended period, the greenback would remain broadly weak. In case there is no rate hike, a brief delay is still likely, before a potential hike depending on the strength of inflation and growth data. Thus the US Fed policy outlook is not favourable for the greenback.

The rupee thus would have support from a weaker US dollar. But given high oil prices, any significant improvement in the rupee’s value is unlikely. The rupee is likely to trade in the range of 46.40 - 46.90, with some downward bias.

The author is Senior Economist, ABN AMRO Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com