LONDON Feb 12 Sterling surged on Wednesday as money markets moved to factor in a UK interest rate rise earlier in 2015 than previously thought after the Bank of England upped its economic forecast and pushed up expectations of a rate hike next year.
The bank, struggling to manage market thinking on rates after unemployment fell far more sharply last year than it had expected, raised its forecast for economic growth this year to 3.4 percent from 2.8 percent.
It also said market pricing calling for the first tightening of policy in five years in the second quarter of next year were consistent with keeping inflation on target, prompting a half percent jump in sterling against the dollar.
Dealers said some players had been caught betting on a stronger rebuttal of market expectations for rates by the bank, which had been anxious to stress it would stay on hold for as long as possible to allow economic recovery to bed in.
"Recovery has gained momentum. (BoE Governor Mark) Carney is more upbeat on growth and employment in the UK. The market likes this and is starting to reinvest the pound sold off in January," said Neil Jones, head of hedge fund FX sales at Mizuho.
The move in money market bets on when the bank would actually deliver its first rise was minimal but rate strategists said there was a clear shift in the consensus over the path of policy over the next two years.
Philip Tyson, a rate strategist with ICAP in London, said implied forward interest rates show a quarter point rise was fully priced in by parliamentary elections in May of next year, followed by another 100 basis points by August of 2016. This morning those rates had pointed to those rises only being delivered by the end of 2016.
"Carney's reference to interest rates being at 2.0 percent in three years' time marks a sea-change in policy," said Trevor Welsh, Head of UK Sovereign and Inflation at Aviva Investors.
"Effectively, the Bank of England is now looking at time well within its forecast horizon when emergency interest rates will no longer be necessary."
Sterling jumped to a two-week high of $1.6557, up about 0.6 percent on the day before retreating a touch. . The March long gilt future fell more than 20 ticks after the release to a session low of 109.58 before steadying to 109.78, down 35 ticks on the day.
The short sterling interest rate futures contract for deliver in March 2015 fully priced in a 25 basis point rise in three month sterling deposit rates, although those rates reflect bets on market rather than actual policy rates.
Sterling was the best performer among major currencies in the second half of 2013 on the back of forecasts that the Bank of England would be the first of the developed world's central banks to lift rates after five loose years.
But Carney and other officials have worked hard to talk down those bets, concerned that Britain's recovery is still based largely on consumer credit and house price rises in some cities while real wages and business investment continue to fall.
Britain's next parliamentary elections are set for May next year and finance minister George Osborne has promised to stick to a course of fiscal tightening which calls for the BoE to keep interest rates for business as low as possible.
In a news conference after the inflation report's release, Carney, headhunted by Osborne for the bank, offered numerous notes of caution on the economic outlook, ranging from a strong pound's impact on exporters to a warning that headwinds would persist.
"I was a bit surprised that sterling did so well after the report," said Vincent Crimmins, head of FX strategy and trading at Bank of Ireland in Dublin.
"Carney stressed that the inflationary environment was more benign and, like the ECB (European Central Bank) last week, mentioned concern over the emerging sell-off. That may take some of the shine off this message for sterling."