The pound has been lifted from its lows after the Bank of England disappointed markets by keeping interest rates unchanged. On Tuesday, the pound was higher as investors are now focusing on a February rate rise.

While speaking at a virtual event organised by the Bank of England (BoE), Governor Andrew Bailey stressed that they will have to act and raise rates if they see a clear indication that higher inflation is feeding into wages. His comments did not impact on the market pricing of a rate hike in December. The CME Group's BoE Watch Tool shows a 67.5% chance of a 20-basis points rate hike before the end of the year.

In terms of Brexit, the ball is now in the UK’s court. After the EU clarified that they will act accordingly if Britain were to trigger Article 16, they are now waiting for the UK to make the next move.

Economic growth and Bank of England

The Bank of England’s dovish turn and less aggressive policy is in line with market data and suggests that their interest rate decision was made based on a more restrained and conservative economic growth outlook. The Bank lowered its 2021 growth forecast to 6.7% from August’s 8.5% forecast but raised the 2022 GDP forecast from 2.3% to 2.9%. 2023's forecast has been lowered to 1.1% from 1.3% that it was previously.

Inflation

Inflation is expected to go over the 2.0% target in the coming months and the Bank could act by raising interest rates if it deems appropriate. Bank of England Chief Economist Huw Pill said on Friday Nov. 05 that he believes the pace of wage inflation will surpass both those of the Eurozone and the US.

A more measured Bank means that there are less risks for early tightening, especially if inflation proves to be transitory. This will also support economic growth and households which are already struggling with higher costs.

Economists do believe that the Bank of England will still raise interest rates to fight inflation in the near future, as they expect hikes in December and February.

Other possible factors to consider for pound volatility

  • As a procyclical currency, the pound goes up when global stock markets are strong and falls when they fall. If the pound weakens it is usually against stronger safe havens such as the US dollar, the yen and the franc. For now, market sentiment is positive, and this has given fresh impetus to the pound.
  • Brexit tensions are growing, and this could potentially impact the pound. Ireland’s foreign minister Simon Coveney warned that the EU-UK Trade and Cooperation Agreement could be dismissed if the UK triggers Article 16 and rewrite the protocol on Northern Ireland. The protocol, which is part of the EU-UK withdrawal agreement, was agreed in order to avoid a north-south trade border on the island of Ireland. Protestant Unionist parties have rejected the agreement, and two buses were set on fire in the past week. If the UK fails to maintain a border in the Irish Sea, then this will threaten Ireland’s economic rights as an EU member and it will be unacceptable by the 26 EU member states. Without a border, animal and plant products will enter the EU single market, without full legal controls. Ireland’s goods won’t be trusted, and checks will possibly be required in order to enter the EU. Markets will await any updates on Friday, following the EU and UK's chief negotiators meeting this week.

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The pound has fallen since last week’s Bank of England (BoE) monetary policy decision to leave the Bank rate unchanged at 0.10%. While it is expected to stabilise the following days, analysts do not anticipate considerable gains for the pound in the near term.

The BoE’s decision to keep monetary policy unchanged took markets by surprise but it chimed with members of the Monetary Policy Committee comments that the Bank wanted to wait and see further evidence about the state of the economy and the health of the labour market, especially the impact of the furlough scheme which ended in September. Analysts still expect a February rate increase instead of one in December.

Possible interest rate rise

The BoE wants to wait and analyse the impact that the end of the furlough scheme will have on the economy, and employment in particular, before making any decisions on raising interest rates. Some of the data will become available in December and more later in January and February. This is why the November interest rate rise was too soon, whereas other ones in December, February 2022 or some time later, appear to be more likely possibilities.

Before the next Bank of England meeting on the 16th of December, analysts and policymakers will have the chance to examine two jobs reports and two inflation reports, which will determine how the Bank will act if there is to be a 15bp December hike. Since markets have not yet priced in a December move, there could be potential for Sterling to rise.

Pound outlook

Analysts believe that there is still potential for the pound as markets digest the news and adjust to a less aggressive policy response in the next meetings.

At the same time, for inflation to return to a target that will be within expectations, the Bank rate will need to rise. The Governor of the Bank of England, Andrew Bailey, said that the BoE would not raise rates to 1 per cent by the end of 2022, because according to the bank’s forecasts inflation would fall below its 2 per cent target in the medium term if they tightened monetary policy too much. Higher inflation is expected to be transitory, leading to an increase in consumer prices, which would have been higher if interest rates rose even a little. The Bank, however, does not expect inflation to fall below 3 per cent until the spring of 2023, which means there will be a period of higher inflation.

Brexit

Brexit is adding some pressure on the pound at the beginning of this week, as reports that the UK is preparing to trigger Article 16 of the Northern Ireland Protocol are growing. Senior Government and EU figures have held discussions to prepare on the possibility of the UK triggering article 16 of the Northern Ireland protocol, a move that both Dublin and Brussels expect in the coming weeks. The move could create a crisis in EU-UK relations. Minister for Foreign Affairs Simon Coveney said that the EU could retaliate by withdrawing the entire free trade and co-operation agreement, reigniting fears of a “no-deal Brexit” and tariffs on trade.

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The pound fell following the Bank of England’s decision on Thursday to keep interest rates unchanged. The decision has taken markets by surprise whose expectations for a November rate hike were very high. Markets are now lowering their expectations for future UK interest rate hikes, as it was also suggested that the December rate hike might also be postponed.

The disappointing news has hurt the pound, which experienced the biggest fall since 28th of September. With the market expecting more than one hike and the bank rate going as high as 1.10% by June 2022, the news was really unexpected. Economists believe that a December or February hike is still possible, which could offer support to the pound. On Friday, the pound remained lower, but tried to stabilise.

Bank Decision

The Bank explained that they have postponed the rate hike as they wanted to wait and see the impact of the government's job support scheme which ended at the end of September.

Uncertainties such as rising energy costs impacting households, ongoing supply chain disruptions, and Brexit tensions could all affect economic recovery. Inflation is a key concern for policymakers as  is expected to rise to around 4% in October and 5% in April 2022. The MPC stated however that inflationary pressures were “most likely to prove transitory.”

Rates could rise in the coming months

The Bank of England noted that interest rates could rise in the coming months if the economy improves. The key question now is whether the Monetary Policy Committee will announce the next rate in February when it produces its new forecasts. The possibility of a rate hike in December is just below 50%.

If there is a rate hike in December this will depend on November's job report for the October period. The labour market report on 16th of November is expected to show positive figures that reflect a healthy labour market which could support a small interest rate rise. A positive jobs report could therefore offer support to the pound.

Economists at MUFG Bank expect interest rate hikes and they have warned that the pound could fall further if the Bank fails to curb inflation. They said: “We still believe that the BoE will raise the policy rates closer to 1.00% by the end of next year. We have only pushed back the timing of our forecast for two further 0.25 point hikes in 2022, and now expect those to be delivered in May and August bringing the policy rate to 0.75%. We remain sceptical though that it will rise beyond 1.00% in 2022.”

They added that downside risks for the pound could continue building if markets become more concerned that the BoE will fail to respond to higher inflation.

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The Bank of England’s policy decision is due out at 12GMT on Thursday. The question of whether the Bank will raise interest rates today for the first time since the pandemic is on every trader’s and financial analyst’s mind. The Bank is in a difficult position as it has created uncertainty about its intention to raise interest rates and whether now is the appropriate time.

Governor Andrew Bailey’s difficult position

For many analysts, the Governor of the Bank of England, Andrew Bailey, seems to have made a mistake by exaggerating the prospects of an interest rate rise. City traders are now expecting an interest rate rise and the governor will be criticised today whatever happens. If there is an interest rate hike, it will appear that the Governor was forced to deliver it so he wouldn’t disappoint markets. On the other hand, if rates do not rise, he will be blamed for signalling that interest rates were going to rise. If rates remain unchanged, and inflation pressures prove to be temporary, then this will be the least bad alternative.

Previous Monetary Policy Committee meeting

In the last MPC meeting in September, all 9 members voted to keep rates at their current level of 0.1% as heightened global cost pressures were said to be temporary. Although nothing has changed since September, a possible reason to raise rates would be to control inflation. However, economists have pointed out that this is unnecessary as inflation goes up temporarily following events such as the pandemic but eventually things return to normal.

Rate hike could push household costs higher

A rate hike will hurt households which are already struggling with rising energy costs and could push up the cost of borrowing on credit and increase mortgage costs for those who do not have a fixed rate. With supply chain problems also affecting growth, a rate rise could also weaken economic recovery.

Some of the reasons that inflation has been higher, such as rising gas prices and raw material shortages are temporary, so it will be damaging to raise interest rates early, as some economists have argued.

Thomas Pugh, economist for RSM UK, also believes the Bank will wait and not hike today: “But at 63% probability, this is still a close call. We expect the vote to be 5v4 in favour of leaving interest rates at 0.1%. This might imply a glass half-empty/half-full policy of keeping the BoE rate at near-zero for another MPC meeting, or two, with forward guidance preparing the markets for a rate hike in December or early 2022.”

How will the pound react?

A cautious Bank that announces a rate hike in November could push the pound lower, as markets are expecting higher rates over the course of 2022. Other analysts also support the view that the pound might weaken as possibly the Bank will find it difficult to satisfy market expectations.

With the market already expecting rates to rise towards 0.50% by year end, any hawkish surprises from the Bank will be limited so the potential for the pound to rise further will also be limited.

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The pound has dropped against the euro and the US dollar ahead of Thursday's Bank of England policy meeting as investors have begun readjusting their positions.

The Bank of England will deliver its latest policy decision alongside the quarterly Monetary Policy Report and expectations for a rate rise are high.

The pound has appreciated over recent weeks on expectations that the Bank of England will push the bank rate higher by 15 basis points to 0.25%. However, the drop at the beginning of the week suggests that markets are divided about the Bank of England’s interest rate decision, as many are now expecting a delay to the rate hike or a more cautious tone from the bank.

Bank of England interest rate hike

ING economists expect a 15bp rate hike, but they believe the bank will remain cautious, as they may lower their medium-term inflation forecasts and remain divided about a rate hike. Any surprising move by the bank will push the pound lower. While members of the Bank have highlighted the need to act as inflationary pressures rise, the likelihood of a November hike has now fallen while the likelihood of a December rise has risen. This has affected the pound, which has underperformed the last few days.

The Chicago Mercantile Exchange’s measure of interest rate futures, known as BoE Watch, has noted that the possibility of a rate rise in the UK this week is 100%.

Confusion among investors

Contradictory data has confused investors over which direction the central bank will go. Financial markets show that many investors are anticipating a hike, while City economists expect rates to remain at historic lows. The views of economists are in line with MPC members Silvana Tenreyro and Catherine Mann, who have warned that an interest rate rise could threaten economic recovery which is already slowing down.

Governor Andrew Bailey, chief economist at the Bank of England Huw Pill and former Citibank economist Michael Saunders, have all highlighted the importance of acting to control inflation. Bailey has characteristically stated that the bank “will have to act and must do so if we see a risk, particularly to medium-term inflation.” Deputy governor Sir Dave Ramsden is also one of the hawkish members and supports raising rates from their historic lows. If four members of the committee are in favour of higher rates, then one more member is needed to succeed. It will be interesting to see what Deputy governor, Ben Broadbent, will vote as he has never gone against the governor in his seven years on the Monetary Policy Committee.

Deutsche bank economists also believe that the BoE would deliver its first rate hike of 0.15% and that the MPC will end its QE programme a month earlier by cutting £20bn from QE.

Others have noted that Bailey would want to avoid disappointing markets, even though a rate hike was yet not a solid reality.

The confusion about what decision the Bank will make on Thursday’s meeting is largely related to the wide range of contradictory views by various analysts and economists.

 

Pound reaction

Sterling’s performance will also depend on the inflation forecasts of the Bank's Monetary Policy Report.

If the Bank proceeds to raise rates twice, the Bank Rate will go up to 0.50% over the next 3 months, which will boost the pound.

Markets expect a number of rate hikes in 2022 which would take the Bank Rate to 1.00%, but economists have noted that they will be disappointed.

Whatever the pound’s reaction ahead of Thursday, it will set the tone in the following days, so if it remains under pressure then markets might turn pessimistic.

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The pound fell on Wednesday despite the UK budget statement, which was in line with expectations. There was no indication that Chancellor of the Exchequer Rishi Sunak’s budget announcement contributed to the market movement. The fall is possibly linked to a drop in the yield of long-duration UK government bonds and shows that markets expect the government to reduce borrowing in the coming years.

2021 Budget

In general, news about today’s budget statement was positive about the economic outlook, regardless of the fact that there was no fiscal stimulus announced. Sunak, said he had asked the Bank of England to remain committed to controlling inflation and keeping it low and stable, as anything above 2.0% will not be favourable in the long term. Next Thursday, with the Bank of England meeting, pound volatility will be expected.  

Rishi Sunak said that his budget delivers a stronger economy, stronger growth, public finances and employment, so that it is possible to begin building the economy post-pandemic. As he noted: “Let there be no doubt: our plan is working.”

Growth

Sunak said overall spending will increase by £150 billion, the "largest increase in a century", as the economy is expected to grow and expand 6% in 2022. The chancellor said that forecasts from the Office for Budget Responsibility (OBR) show the economy will grow by 6.5% this year, 6% next year, 2.1% in 2023, 1.3% in 2024, and 1.6% in 2025. Unemployment is forecast to reach 5.2%, down from a forecast of 12% last year.

Inflation

The chancellor said inflationary pressures are currently impacting on the UK economy and the government will make sure to support households. The Office for Budget Responsibility (OBR) is expecting inflation to be around 4% next year.

Borrowing

Sunak said that will set new “fiscal rules” for public finances. During “normal times” the state should only borrow to invest in growth while balancing everyday spending. In the current financial year 2021-22, borrowing will be 7.9% of GDP, and will fall to 3.3% in 2022.

Employment and skills

The chancellor said the government will raise government spending on skills and training by £3.8bn. The government will create a UK-wide numeracy service called Multiply to help 500,000 adults. This is part of the government’s commitment to improving lifelong learning and productivity. While a lot of this has already been announced, the 43% increase in spending is considerable.

Business taxes

The bank surcharge will be cut from 8% to 3%. Business rates will be changed to help companies and a new 12-month relief will be provided to companies to invest in their premises. The incentives are worth £750m. Sunak said that 2022’s intended increase in the business rates multiplier will be terminated. There will also be a 50% business rate discount for companies in retail, hospitality and leisure. The cut is worth £1.7bn. The chancellor highlighted that “This is the biggest single year tax cut to business rates in over 30 years.”

Taxation and universal credit

Sunak also announced that the taper rate in universal credit will be cut from 63p to 55p. This will be worth more than £2bn. The work allowance will be increased by £500.  In regards to taxes, Sunak confirmed: “By the end of this parliament I want taxes to be going down, not up.”

The reforms to the universal credit system will enable only those in work to keep more of what they own and will encourage employment.

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The pound fell following disappointing retail sales and a drop in the GfK Consumer Confidence survey, but reversed losses after the release of better-than-expected Preliminary PMI data for October.

PMI

The Markit/CIPS Manufacturing PMI for October came at 57.7, higher than the expected 55.8. The Services PMI also came at 58, higher than the 54.5 forecast and September’s reading of 55.4. The Composite PMI came in at 56.8, also above the forecast of 54 and the previous month's 54. IHS Markit’s Chief Business Economist Chris Williamson said that the flash PMI data was higher than the average of 54.0 before the pandemic and showed that the GDP grew each quarter 0.7%.

Markit reported that activity increased as the private sector growth reached a three-month high, with strong business and consumer spending. Service providers were the main driver behind the recovery. Employment numbers also rose as improved customer demand and confidence about the business outlook strengthened. Pressures from higher costs and staff shortages will however persist.

Retail Sales

Earlier on Friday, the ONS reported that UK retail sales fell in September. The pound dropped following the disappointing news, as it was shown that the economic slowdown might be worse than expected. Retail sales for September were down 2.6% year-on-year, lower than the expected 1.7%.

Even as we move into the Christmas period, higher gas prices will keep operating costs high and reduce consumer spending power.

November interest rate hike

The pound will also be at risk from the Bank of England disappointing markets and not proceeding as expected with the interest rate hikes. The markets now see a November interest rate hike (from 0.1% to 0.25%), as a 56% possibility, which is down from 90% earlier this week, after Bank of England governor Andrew Bailey suggested the BoE will have to act to control inflationary pressures.

BoE chief economist Huw Pill told the Financial Times that the Bank would have a "live" decision to make at its next meeting on the 4 November. While he declined to say how he would vote at the Bank’s meeting next month, he said "it is finely balanced": "I think November is live."

The UK interest rate has been at a historic low of 0.1% since March 2020. The view that November’s meeting is “finely balanced” may have encouraged traders to reconsider the odds of action next month.

GfK Consumer Confidence survey

Consumer confidence was also down in October, at its lowest since February. Consumers are concerned with the future of the economy. The possibility of a cold winter coming while dealing with fuel and food shortages, Brexit and surging inflation, as well as interest rates affecting the cost of borrowing, not to mention Covid-19 cases rising, does not sound especially promising. The Petrol Retailers Association (PRA) has said that all-time highs seen in April 2012 of 142p per litre for petrol and 148p for diesel will be surpassed by the end of October. Average prices for petrol and diesel had reached 141.35p and 144.84p respectively on Tuesday, according to Experian Catalist UK.

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With Bank of England policymakers signalling that the central bank is moving towards an early interest rate hike, traders have been trying to figure out what this means for the pound. Economists and forex analysts have offered both positive and negative comments about the bank’s intention to raise interest rates, with other analysts turning neutral. 

Interest rate rise could hurt the pound

Markets are now expecting the BoE to raise interest rates in November, with further rates to follow by the end of 2022. However, the link between higher interest rates and a stronger currency has been broken, unfortunately, due to the current energy crisis, higher costs and a struggling economy due to the pandemic. Within this environment, many analysts are concerned that an early rate hike will actually create more problems and that it could be reversed within two years, creating further uncertainty for the currency.  

Jane Foley, head of foreign-exchange strategy at Rabobank, said that “There is a lot of uncertainty,” in London. “It’s easy to argue that rates going up will strengthen the pound. But the risk of a policy mistake means the BOE could hike soon but then won’t be able to follow through” with more tightening.

Bank of England Policy Mistake?

Markets are unsure about the outlook for the pound, with institutional fund managers limiting their trades against the pound and others betting for the pound to strengthen. For some analysts, the BoE tightening will provide some support for the currency but, for others, the lack of economic growth will eventually reverse any gains.

Additionally, further challenges remain. Brexit tensions between the UK and the European Union over Northern Ireland could escalate into a trade war, but Prime Minister Boris Johnson has offer assurances that solutions will be delivered within the week.  

Despite the Bank of England’s Governor Andrew Bailey’s reassuring comments that the Bank will do what it takes as inflationary pressures rise, traders are concerned about the pound outlook in the longer term.

Pound remains “insensitive” to UK rate expectations

While many foreign exchange analysts have voiced their concerns about the pound outlook if the Bank of England proceeds to an early set of interest rate rises, HSBC strategists believe the pound is “insensitive to the continued hawkish drift in UK rate expectations.” Even if inflation falls at the end of 2022 and there is no need to raise rates higher on a long-term basis, HSBC says there is more to the pound than an automatic fixation on the BoE.

Indeed, the pound is not driven solely by the desire of the Bank of England to raise or not rates. A they argue, the pound’s performance has been mainly determined by global forces. It rises against the euro and US dollar on positive investor sentiment and falls when global markets struggle. As investors recently digested global concerns about the pandemic and the energy crisis, buying interest for the pound has returned, pushing Sterling higher.

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UK inflation has fallen slightly but remains above the Bank of England’s target. According to data from the Office for National Statistics (ONS), UK CPI inflation eased slightly to 3.1% in September, from 3.2% in August—the highest in nine years.

The pound softened on Wednesday morning following the inflation data, as analysts expected the September reading to remain at 3.2%.

The slowdown is mostly due to the effects of lower prices of dining out last month compared to last September, when prices rose following the end of the Eat Out to Help Out scheme.

BoE

The data comes after Bank of England Governor Andrew Bailey said that the central bank will have to act to ease inflationary pressures – raising expectations for earlier rate hikes. According to economists, the bank’s task is a difficult one, as it expects inflation to reach 4% in the current quarter, with higher interest rates expected to ease it. However, the economy is struggling with higher costs and rising commodity prices, which interest rates have no power over.

Inflationary pressures rise

The cost of UK company goods and services continued to rise last month, affected by the supply chain crisis. Output price inflation rose to 6.7% per year in September, from 6% in August. Inflationary pressures are building in the economy as producers increased their prices, passing on costs to consumers. Companies reported that input prices increased by 11.4% year-on-year in September. Manufacturers faced commodity costs and transport costs due to shipping issues and a shortage in lorry drivers.

Economists: inflation is temporary

Economists are warning that September’s fall in inflation will be temporary. Costs rose due to supply issues and the higher energy price cap. The persistent supply-chain disruptions and energy price effects could push inflation higher above 4% early next year.

Senior economist at Royal London Asset Management Melanie Baker, expects more inflation. He warned that energy bills could push consumer price inflation further, which will reduce real income growth for many and add to some of the economic challenges in 2022.

Paul Dales of Capital Economics predicts inflation to reach 5% next April, when Ofgem hikes the energy price cap again. He noted: “However, this feels a bit like the lull before the storm as the 12% rise in utility prices on 1st October will probably lift CPI inflation to around 3.8% in October. And we think inflation could then climb to around 5.0% in April next year due to a further rise in utility prices and the upward influence from global/domestic product shortages. With underlying wage growth and inflation expectations rising, the BoE is concerned that higher inflation will become embedded in the system. That’s why it become much keener to raise interest rates.”

Dales explained that he doesn’t expect interest rates to be raised as far as 1.00% by the end of next year, since higher inflation will weaken the outlook for activity and with supply shortages easing, inflation will eventually fall to around 2% by the end of next year.

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Sterling reached a 20-month high against the euro on Monday after Bank of England Governor Andrew Bailey sent another signal that the central bank is heading towards raising interest rates as inflation risks rise. On Tuesday, the British currency held on to its near 20-month high gains against the euro and has reached a new one-month high against the US dollar. The main factor supporting the pound is expectations the BoE will raise rates, with investors speculating on a rise to 0.25% by December, or even earlier by November. Traders will be focusing on the release of the UK CPI inflation data for September on Wednesday and Friday’s PMI data for further clues.

Despite the pound’s excellent performance, some foreign exchange analysts are wondering whether the recent gains can be sustained in the long term.  

Warnings

Many economists and analysts have warned that the Bank of England’s intention to return interest rates to pre-pandemic levels could be a huge mistake that will impact on economic growth and push costs higher for households that are already under pressure. Higher interest rates, combined with zero growth and high inflation will hurt both the economy and the pound.

Others have noted that the pound won’t be supported for a long time by the Bank of England’s higher interest rates due to persisting supply chain issues and a struggling labour market.

Former Bank of England Monetary Policy Committee Member, David Blanchflower, said that raising rates very soon will be a disaster and “foolish.” He told BBC Radio 4 that interest rates are at 0.1% but economists warn that inflation could peak at 6.0%. Former MPC member Andrew Sentance laughed at Danny Blanchflower’s comments saying that he did not understand monetary policy.  With economists being torn about the prospect of higher interest rates, it is not surprising that there are so many differing views. However, markets have priced in a rate hike and expectations remain solid that an interest rate hike is possible in November.

Bank of England has been Misunderstood?

At the same time, analysts argue that the BoE Governor’s recent comments have been misunderstood and that a November rate rise is unlikely. Bailey has stated that the Bank will act if there are inflation risks in the medium-term and that the Monetary Policy Committee will wait and see until December when labour market data is available.

Also, for some analysts, the subsequent rate hikes being priced in by investors are a bit extreme as possibly two rates maximum by the end of 2022 sounds more reasonable. However, any recent hike expectations being priced out could also negatively impact on the pound.

Others have argued that, if indeed early interest rate hikes will be disastrous to the economy, then pricing out these rate hikes will possibly support the pound.  With so many different arguments, it is not yet clear how the pound will react. Some commentators have even gone as far as to suggest that the pound will fall whatever happens. For example, if the BoE ends up being more dovish and does not raise interest rates, it will end up disappointing markets. On the other hand, if it does deliver early rate hikes it might end up making a policy mistake. Nonetheless, Friday’s PMI data might offer further guidance: if it comes stronger than expected then the pound will strengthen and so will the case for raising interest rates.

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