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Asymmetric Risk Ahead for British Pound as BOE Weighs Rate Hike

Asymmetric Risk Ahead for British Pound as BOE Weighs Rate Hike

Talking Points:

- Asymmetric risk exists for the British Pound around the BOE rate decision today, given the high degree to which a rate hike has been priced-in (91% per overnight index swaps).

- Accordingly, there is limited upside potential for pairs like GBP/USD, and much greater downside potential.

- Retail trader sentiment suggests the near-term outlook for the US Dollar is neutral.

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The Bank of England is meeting today in what result in the first rate hike in nearly a decade. According to markets (overnight index swaps) there is a 91% implied probability of a hike. In support of this point of view, since mid-August, economic data trends have firmed up (the Citi Economic Surprise Index was -51.9 on August 15, today it is +7.2). The 'big one' that the BOE has everyone talking about is headline inflation, currently sitting at +3% y/y.

However, the inflation outlook going forward looks less severe. One of the main reasons for the spike in inflation was the base effect in the trade-weighted GBP brought on by Brexit. Now that the GBP is up y/y (it bottomed in early-October 2016 post-Brexit vote), BOE policy officials think headline inflation will begin to recede naturally.

As such, if the BOE hikes, it won't be the beginning of a rate hike cycle - it will be 'one-and-done.' Consider it a 'dovish hike.'

The UK is facing a pseudo-/mini-stagflationary state right now. Some will correctly point out that the labor market is doing well, which is why this is not true staglfationary state. But inflation is high and growth is weak (confirming the other two aspects of stagflation), leaving the BOE in a policy bind: raise rates to stave off inflation at the risk of choking off growth; or keep rates lower for longer to keep growth conditions primed and hope that the inflation doesn't rise any further.

Chart 1: GBP/USD Daily Timeframe (August 2016 to November 2017)

With a 91% implied probability, much of the upside is priced in. Likewise, given my outlook for a 'one-and-done' hike, the forward guidance on rates shouldn't be that helpful for the Sterling. Thus, there is asymmetric risk for the British Pound tomorrow: limited upside potential, greater downside potential.

If we get the 'hawkish hike', GBP/USD could trade into the mid-1.3300s; the base case for a 'dovish hike', which could send GBP/USD back towards 1.3100; and in the event that there is no hike, GBP/USD could slip below 1.3000. In the event of strength in GBP-crosses, GBP/CHF or GBP/JPY would be the preferred places to look, given recent price action.

Chart 2: GBP/JPY Daily Timeframe (November 2016 to November 2017)

Read more: EUR/USD Head & Shoulders Still Valid; Asymmetric Risk for GBP/USD

--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.