BOE ditches dovish stance as GBP flies high

Could anything overshadow the Bank of England’s Inflation Report today? You bet, the news that the government had lost a court case, which means it may have to put the triggering of Article 50 to a vote, was rocket fuel for the pound. GBP is the best performer in the G10 so far in November, even though we are only three days in, there is good reason to suspect this rally may have legs.

The Bank of England’s Inflation Report confirmed that the Bank has shifted to a neutral stance from a dovish stance, which led to the market rapidly pricing out the prospect of a rate cut this year and next. The overnight index swaps market is pricing in a mere 4.7% chance of a cut in rates in the middle of next year, by the end of 2017 the market is pricing in a near 20% chance of a hike on the back of Bank’s upward revision to its inflation forecast.

If the price is right…

The BOE now expects prices to stay above its 2% target rate out to 2019, back in August the Bank’s central projection saw weaker prices staying below target for its forecast period. Although the Bank has said that it will look through a period of higher prices caused by sterling weakness in the past, today the Inflation Report made clear that the Bank will not tolerate an indefinite period of above target inflation, suggesting that it may act to dampen price pressure down the line.

The Bank said that policy expectations are fairly evenly balanced: while the Bank may raise rates if the UK experiences a prolonged period of high inflation, it reiterated that it still has the ammunition to boost the economy if Brexit negotiations weigh on growth.

Pesky GDP forecasts weigh on BOE reputation

The Bank has also revised up its forecast for growth, GDP in 2017 is now expected at 1.4%, up from 0.8% in August. However, while near-term growth might be higher, the outlook for longer-term growth remains weak, the Bank revised down its GDP forecast for 2018 to just below 1%, it was projected at 1.5% in August. Although the Bank’s central forecast does not expect the UK to plunge into recession on the back of our exit from the European Union, it is expecting a prolonged period of low to mediocre growth that could impact future investment and jobs prospects.

So, can we call this a hawkish Inflation Repot? Compared to the last one, yes, the Governor sounded much more upbeat than he did a few months back, however, he did remind us that Brexit risks are still alive and well. When asked his opinion on the legal ruling that could see Theresa May forced to delay triggering Article 50, the Governor was diplomatic, however, he said this was another reminder of the type of uncertainty that can be caused by Brexit.

High Court ruling: Not all uncertainty created equal

The FX market does not seem to mind this uncertainty, with the pound rallying on the back of the decision from the High Court. The FTSE 100 has is the worst performer in Europe, suggesting that the inverse correlation with the pound is alive and well. However, the FTSE 250 rallied on the back of the announcement, as this index is more closely associated with the fortunes of the         UK economy. Some elements of the FTSE 100 also cheered the High Court’s decision. The real estate sector is by far the best performer on the FTSE 100 today, and is up nearly 3%. The real estate sector is also closely aligned with the UK’s economic fortunes, so if the market thinks that Brexit is bad news for the UK economy, any delay to triggering Article 50 should be warmly welcomed, even if it signals more uncertainty ahead. The real estate sector makes up just over 1% of the FTSE 100, so its large increase today has not been able to prop up the broader index.

So where does this leave UK asset prices?

Although global markets remain at the mercy of the outcome of the US election, if Hillary Clinton does manage to win next week, then the GBP may continue to outperform the G10. The Court ruling on Article 50 opens the door to a delayed Brexit, which seems a good enough excuse for the FX market to extend this GBP rally further. The increase in the BOE’s inflation forecast could also keep upward pressure on UK Gilt yields, which are the building blocks of a stronger GBP, in our view.

Overall, US election fears weighing on the dollar, and Brexit fears temporarily receding, could trigger a break above 1.25 in GBP/USD in the near term. If this happens then we could see GBP/USD move towards the 1.25-1.30 range between now and the Fed meeting in December.