Sterling Steals Show

Sterling has moved to new session highs, even as the euro is pinned near its lows.   The market's response to the Bank of England's Quarterly Inflation Report and updated forward guidance is going to frustrate officials.  Not only is sterling gaining on a trade weighed basis, which, if sustained, is tantamount to  some tightening of financial conditions, but UK interest rates are also rising.  

The implied yield of the December short sterling futures contract has risen 9 bp on the day, and the bulk has come after the BOE's report.   The yield of the 10-year gilt is up 6 bp on the day and is now 111 bp on top of Germany, which is at the upper end of where the spread has been since the late 1990s.  

Carney's concern about  the recovery being unsustainable was diluted by the upward revisions to the growth forecasts for this year and next.   The BOE's  Dale projected in increase in average earnings that exceed inflation in the second half of this year.   The hawkishness was underscored again by Bean who suggested the central bank hopes to start tightening before a full recovery is in place. 

The bottom line is that while the general view remains of a risk of a BOE rate hike in Q1 2015, many observers and investors see heightened risk of an earlier hike, as in late 2014.  The market went into this week thinking that it was a close call who would raise rates first the Fed of the BOE, Yellen seemed ultimately more convincing than Carney. 

Next week the UK reports January CPI figures next week.  Due to base effect, the year-over-year rate is likely to rise from the 2.0% seen in December.  This too may help underpin sterling.  We note that in recent weeks, long sterling positions have been trimmed considerable, and the short-term market may not be as long sterling as it may appear. 

While sterling appears poised to challenge the $1.66 area on its way to the multi-year high set in late January near $1.6670, there is potential over the medium-term toward $1.70.   For its part, the euro has been pushed below GBP0.8200.  The GBP0.8160 is the next important technical level and a break of it, would spur talk of a test on GBP0.8000.