Investors' Query to the Bank of England: Is This a One-Off Rate Rise?

Investors are certain the Bank of England will raise rates Thursday. They're also certain the central bank won't do it again for a long time. That means there is a potential for surprises to shake U.K. markets.

Derivatives markets assign an 85% probability to U.K. officials raising interest rates this week for the first time in a decade. Over the past two months, the pound has gained 2.5% and 4.3% against the U.S. dollar and the euro respectively, fueled by hints from BOE officials that monetary policy is set to be tightened.

Likewise, yields on 10-year gilts have risen to 1.333% from 1.060% during the same period.

Key for the U.K. currency and bonds now is whether the BOE's rate rise will be read as the start of a tightening cycle.

"That's the crux of the matter, is it 'one and done' or there's more to come?" said David Katimbo-Mugwanya, a sterling fixed-income fund manager at EdenTree Investment Management, who thinks the gilt market is likely to sell off Thursday as sterling rallies.

Some analysts warn that markets show signs of overconfidence. Trading in derivatives called overnight index swaps shows that investors believe the central bank will move its benchmark rate back to 0.5%--where it was before the Brexit vote last year--and leave it there until November of next year.

But officials could signal otherwise, economists said.

"There's a real vulnerability in the market if they indicate the next hike might come a bit sooner, and that would be good for sterling," said Stephen Gallo, head of foreign-exchange strategy at BMO Financial Group.

Such a surprise could drive sterling up between 0.7% and 1.3% against the dollar, according to a range of estimates by economists. Yields on 10-year gilts could edge up, closer to the 1.5% mark.

Speculators now have a small bet on the pound going up, according to the U.S. Commodity Futures Trading Commission. It is the first time this has happened since late 2015.

A rise in the pound would dent the FTSE 100, since two thirds of revenues of companies listed there come from outside the U.K.

According to Viraj Patel, foreign-exchange analyst at Dutch bank ING, it is unlikely that BOE officials will be able to deliver the dovish message that investors expect, because it would limit their options to raise rates sooner if they need.

"How would the BOE even signal a one-off rise?," Mr. Patel said. "No central bank will do that, they want to keep it open-ended." He expects sterling to hover around $1.35 at year-end.

Jitters around the BOE's decision underscore an important issue for U.K. markets: Even though most investors are very confident that rate-setters will decide to nudge up borrowing costs, there is a large degree of confusion about why they are doing it.

Over the past few months, the case for raising rates has sometimes been argued in conflicting ways by different officials at the central bank. BOE Gov. Mark Carney has voiced concern about Britain's decision to leave the European Union hampering the U.K.'s growth potential, which would make central bank stimulus ineffective and drive up inflation unless rates were increased as a response.

At the same time, BOE Chief Economist Andy Haldane has often expressed optimism about the health of the British economy, which expanded at a faster 0.4% in the third quarter, official figures showed last week. This may pave the way for higher interest rates without fear of harming economic growth.

As a third possibility, recent research by the U.K. central bank suggests that sterling's depreciation after Brexit could have a more lasting effect than previously expected, as companies continue to pass on the cost of higher imports to consumers in the following months. Some economists believe that policy makers could be driven to offset this effect by pushing up rates and shoring up the pound.

According to Kallum Pickering, an economist at Berenberg Bank, how many of the BOE's Monetary Policy Committee vote in favor of a rate increase will "matter a lot" for markets and how they read the decision.

On average, analysts expect seven out of nine members to vote in favor of increasing rates, so a larger consensus would probably spark a reaction.

"If all MPC members back the hike, markets will say surely it's not going to be one and done," Mr. Pickering said.

Write to Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

November 01, 2017 10:42 ET (14:42 GMT)