Rallying sterling may be at risk of BoE verbal intervention

LONDON Wed Dec 4, 2013 7:08am EST

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LONDON Dec 4 (Reuters) - Sterling's rally to five-year highs against a basket of currencies on robust UK data could raise the risk of verbal intervention by the Bank of England, which wants to shift the economy towards more exports.

Any sign that the BoE is becoming uncomfortable with the strength of the currency would see the pound give up some of the strong gains it has made in the second half of the year.

The BoE's Monetary Policy Committee started a two-day meeting on Wednesday and no change to policy is expected. But sterling's recent strength and its potential to hurt the recovery and a rebalancing of the economy towards exports could be discussed, some analysts said.

A stronger pound, which has risen on expectations that the BoE could be among the first major central banks to tighten policy, makes exports more expensive and can hurt external demand and overall growth.

Some major central banks, including the Bank of Japan and the Reserve Bank of Australia have flagged concerns about the strength of their currencies, driving down their value.

While the chance of the BoE stepping in immediately are seen as low, analysts say it may not stay silent forever.

"As the BoE's strategy is all about securing the strongest recovery possible whilst it can, then the pound is no longer doing it any favours," said Neil Mellor, currency strategist at BNY Mellon. "The sooner it draws attention to the incongruity of such a stellar pound performance, the better."

The trade-weighted sterling index hit a five-year high of 85.1 on Tuesday. The pound has gained more than 10 percent against the dollar since it struck a three-year low of $1.4814 on July 9.

It traded at $1.6360 on Wednesday, having hit a two-year high of $1.6443 and an 11-month high against the euro on Monday.

It has also gained 20 percent against the yen this year as investors bought the pound on signs of an economic recovery that has raised expectations the BoE will tighten policy much earlier than it has flagged.

LID ON INFLATION

In forward guidance unveiled in August, the BoE said it would keep interest rates low until unemployment fell to 7 percent - something it expected to happen in late 2016. It has since said the jobless rate could fall below 7 percent sooner, but that it still intends to keep policy ultra-loose.

A stronger pound helps drive down the cost of imports and should keep a lid on inflationary pressures. That will help the BoE keep interest rates low for longer.

Annual inflation in Britain is hovering just above the BoE's target of 2 percent and some traders say this is one reason why the BoE could tolerate a higher pound.

"Britain is still one of the few G-10 economies that has above-target inflation. A firmer pound will keep a lid on that," said Chris Turner, chief currency strategist at ING.

"And while we acknowledge that a firmer pound can put the rebalancing of the economy at risk, I do not think that the BoE would want to show any discomfiture just yet."

So far, a firm pound has had little impact on economic activity. Manufacturing and construction purchasing managers' indexes have added to optimism about a UK recovery while data on Wednesday showed the services sector was still growing relatively quickly.

This contrasts with the euro zone where policymakers are grappling with disinflation and a patchy recovery.

"We are still expecting some more gains in the pound especially against the euro and less against the dollar," ING's Turner added.

Some BoE policymakers have expressed some concern, but traders said that unless Governor Mark Carney steps in, sterling bulls are unlikely to be shaken.

Samuel Tombs, an economist at Capital Economics, says the BoE may step in soon. He said the rise in the pound has increased the chances that inflation falls significantly below the 2 percent target next year and threatens rebalancing.

"As a result, the MPC may begin to consider ways to weaken sterling again. Merely expressing concern about sterling's strength earlier this year caused it to fall," he said.

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