Sterling finds support as rate hike expectations take hold

Tom Tong28/Jan/2011Currency Updates

GBP

Sterling rose against the dollar on Thursday, drawing support from expectations that the Bank of England could raise interest rates by mid-year and underpinned by a broad dollar weakness.

The pound also jumped against the yen, which was sold off after ratings agency Standard & Poor’s cut Japan’s sovereign debt rating by one notch to AA minus, saying the country’s government lacked a coherent plan to tackle its mounting debt.

Sterling has found support after minutes of the Bank of England’s January meeting on Wednesday showed BoE policymaker Martin Weale joined Andrew Sentance in voting for a 25 basis point rate rise from a record low 0.5 percent. Analysts said the additional vote to raise rates prompted investors to price in the rising likelihood of an increase in coming months. However, some said weakness in the UK economy, highlighted by news this week of a shock contraction in gross domestic product late last year, would cap the pound’s gains.

“The market is literally reading the minutes as hawkish, and not reading in the context of the weak GDP print,” said Chris Walker, currency strategist at UBS, adding that broad weakness in the dollar was also boosting the UK currency. But he added: “King’s speech after the GDP print and the weak GDP itself suggest that the analysis of the minutes should be put into context a bit.” Walker was referring to a speech by BoE Governor Mervyn King on Tuesday, when King said any decision to raise interest rates would be based on longer-term goals, while acknowledging that UK consumer prices would probably surge in coming months.

EUR

The euro hit a two-month high against the dollar on Thursday after a Eurozone policymaker expressed concern about inflationary pressures, further highlighting a policy divergence with the United States.

The single currency also hit a two-month high against the yen because of the ratings cut described above.

European Central Bank policymaker Lorenzo Bini Smaghi warned on Thursday that an expected rise in imported goods inflation cannot be ignored, supporting the view that Eurozone rates could rise sooner than previously thought.

The comments helped the euro extend earlier gains after a Federal Reserve statement the previous day gave no indication that it may back away from its loose monetary policy contrasting with recent hawkish ECB rhetoric. “The ECB has started to show more concern about secondary price pressures, and the market has acknowledged that,” said Gavin Friend, currency strategist at nabCapital.

German consumer prices rose at their fastest pace since October 2008 this month, offering early signs that inflation in the Eurozone may now be high enough to be of concern to the European Central Bank.

EU-harmonised prices (HICP) grew 2.0 percent year on year in January compared with 1.9 percent in December. The hike missed the 2.2 percent expected by a Reuters poll and was driven in part by gains in volatile commodities prices, but analysts said domestic underlying inflationary pressures were increasing and the case for one or more ECB interest rate hikes within months had been strengthened.

“The case for record low interest rates is getting weaker,” said Berenberg Bank economist Holger Schmieding, who expects two rate hikes of 25 basis points each in September and December.

Aside from further rises in costs of heating oil and fuels as well as fruits and vegetables, Germany’s Federal Statistics Office said January’s increase was also due to a national hike in electricity bills to subsidize renewable energy producers.

“Inflation is back in Germany,” said UniCredit economist Alexander Koch, who warned of upward pressure on the core inflation rate throughout 2011. “The recent strong rise in corporate input prices and also selling price expectations signal a clear upward trend in underlying inflation,” he continued.

Adding to the more hawkish tone, ECB policymaker Lorenzo Bini Smaghi said earlier on Thursday that rises in imported goods prices carried an inflation risk for the euro area, pushing up the single currency and Bund yields.

USD

The dollar fell against most of its major currency rivals on Thursday’s trading session, down more than half a cent vs. the euro, extending EURUSD to a two month high. The greenback also dropped about 60 pips vs the pound.

Losses yesterday came after a report showed that the number of Americans that filed for unemployment benefits for the first time rose by 51,000 to 454,000 in the week ended in January 22. The end results failed to reach expectations for 407,000 claims. In addition, the total value of new purchase order placed with manufacturers for durable goods unexpectedly fell in December by 2.5%, failing to reach projection for a 1.6% rise.

The dollar’s fall has to some extent been moderated due to some positive data. The number of Americans singing contracts to buy previously owned homes rose in December by 2.0%, following a revised 3.1% gain the prior month. Positive data from the American housing sector are vital for the economy, as this remain the most fragile sector in the industry. In addition, orders for US Capital equipment increased in December for the second month in a row. Bookings for equipment like computers and communications gear climbed by 1.4 after a 3.1% gain in November.

Looking ahead to today the most significant news event from the US economy looks to be the Advance Gross Domestic Product. The GDP measures the change in the value of all goods and services produced by the economy, and its release usually has a large impact on the market. Traders are also advised to follow the Consumer Sentiment report which will be released from the University of Michigan.

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Written by Tom Tong

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