Pound, Gilt Yields Slide as BOE Rate-Increase Expectations Ease

The pound and gilt yields fell Thursday as investors rowed back expectations that the Bank of England will raise interest rates in the coming months, interrupting sterling's recent rally and renewing focus on Britain's currency and its effects on the economy.

The pound fell 0.7% to $1.3132 after reaching its highest level against the dollar since September during London morning trading. The decline pushed sterling to its lowest level against the euro since November at EUR1.1050.

Britain's central bank lowered its growth forecasts for this and next year and held its benchmark interest rate steady at 0.25% on Thursday, a move that only two policy makers dissented against rather than the three some analysts expected. Investors were looking for a clearer sign that the BOE will join a growing chorus of global central bankers moving toward an end to the era of easy money. On Thursday, the Czech National Bank raised its key policy rate for the first time in nearly a decade, from 0.05% to 0.25%, sending the country's currency higher.

Higher interest rates tend to attract money looking for the higher yield, boosting the local currency.

"I think it's more steady-as-she-goes from the bank," said Alan Wilson, investment manager at State Street Global Advisors. "The market can see down the line that Brexit will result in economic weakness," he said.

Since Britain voted to leave the European Union in June last year, sterling has dropped around 12% against the U.S. dollar.

Adding to pressure on the pound, the BOE downgraded its forecasts for growth to 1.7% in 2017, a weaker pace than the 1.9% it forecast in May. It also cut its forecast for growth in 2018 to 1.6% from 1.7%.

The U.K.'s FTSE 100 equity index, which is heavily made up of exporters, climbed 0.9% Thursday as the pound fell. The index generates just 33% of its revenues in the U.K., according to FactSet, and its companies tend to benefit as they translate earnings back into a weaker currency. The FTSE 250 index of more domestically focused companies rose 0.4%.

Yields on 10-year U.K. gilts closed at 1.154% from 1.240% ahead of the BOE decision, indicating a rise in prices.

These market moves came even as Bank of England Gov. Mark Carney signaled in a news conference that interest rates may rise at a faster pace than investors currently expect. Investors appeared to be unconvinced.

On Wednesday, derivatives called overnight index swaps suggested that investors expected the BOE's first interest-rate rise to happen in December next year. Following the BOE's meeting Thursday, those derivatives implied they now expect that to happen in May 2019.

Expectations had grown earlier in the summer that the BOE would raise interest rates in the coming months, after three officials broke ranks in June to argue for an immediate quarter-point increase to tame quickening inflation. But recent downbeat readings on consumer price inflation and signs of softer wage growth have kept the bank's hawks on the sidelines, investors said.

In their policy statement Thursday, BOE rate setters said sterling's depreciation, along with a stronger global economy, could still boost British exports.

But many economists are skeptical that Britain can count on an export boost from the weaker pound to shore up the economy as the country prepares to leave the EU.

After the pound's post-Brexit tumble, quarterly export volumes of goods rose by about GBP10 billion ($13.22 billion), but imports increased by roughly GBP12 billion, widening the U.K's trade deficit. Research by bodies such as the International Monetary Fund have found that weaker currencies don't help exporters as much as they once did, because goods sold abroad are increasingly produced using imports.

Those imports became more expensive when sterling plummeted, driving inflation to hit 2.9% in May, putting a squeeze on consumers.

Still, there may be early signs that could be turning round.

Surveys of purchasing managers said that foreign demand rose in July at the second-fastest pace in recorded history, beaten only by April of 2010. In a survey released Wednesday by the Confederation of British Industry, U.K. small and midsize firms reported the strongest export order growth in the three months to July since April 2011. Meanwhile, the effect of imports on prices seems to have mostly run its course, analysts say, with inflation easing back to 2.6% in June.

Since April, sterling has lost more than 6% of its value against the euro. This is more important than sterling's exchange rate against the dollar, because the U.K. exports 43% of its goods to the eurozone, its No. 1 market.

"Firms are clearly in an exporting sweet spot, able to exploit the competitiveness gains from a low exchange rate and a firm global backdrop," said CBI economist Alpesh Paleja.

Still, Mr. Paleja also believes that the boost from a lower exchange rate will fade over time.

--Jason Douglas and Paul Hannon contributed to this article.

Write to Riva Gold at riva.gold@wsj.com and Jon Sindreu at jon.sindreu@wsj.com

(END) Dow Jones Newswires

August 03, 2017 12:13 ET (16:13 GMT)