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.
"The one hawkish element of the (report) ... is that this is basically a blueprint ... as to how the BoE expects to tighten monetary policy," said Stephen Gallo, FX strategist at BMO Capital Markets. "That's sterling supportive."
The pound rose 0.8 percent - its biggest gain in three months - to a two-week high of $1.6589.
The euro, weakened by talk of a negative deposit rate at the European Central Bank, tumbled 1.2 percent to 81.90 pence . That provided a welcome profit for hedge funds who have switched their sterling bets from being against the dollar to against the single currency.
The March long gilt future was down 82 ticks at 109.32. Dealers said some players were caught out betting on a stronger rebuttal of market rate expectations by the bank, which had been anxious to stress it would stay on hold for as long as possible to allow Britain's economic recovery to bed in.
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 is 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 similar rises being delivered only by the end of 2016.
Short sterling interest rate futures - which reflect bets on market rather than actual policy rates - fully priced in a 25 basis point rise in three-month sterling deposit rates in March 2015 and show a substantial chance of a rise by December.
"Carney's reference to interest rates being at 2 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 a time well within its forecast horizon when emergency interest rates will no longer be necessary."
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 years of ultra-loose policy.
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. 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 report's release, Carney, head-hunted 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.
Not everyone thought Wednesday's rise in the pound was justified by Carney's comments.
"We think this probably presents a good opportunity to go short cable (the sterling-dollar exchange rate)," said Alex Edwards, London-based Manager of Corporate Business at USForex, pointing to Fed chair Janet Yellen's comments on Tuesday that the central bank was on track to keep reducing its stimulus.
And Lee McDarby, executive director, corporate FX sales at Nomura International, said sterling's spike was an "over-reaction".
"It has taken a long time for the UK to be able to take advantage of the relatively weak pound for exporters and it would seem that the Bank of England is very conscious not to allow sterling to get too strong," he said.