Don’t expect the Pound-to-Euro exchange rate rally to last indefinitely say analysts at Bank Julius Baer saying markets have let interest rate talk get to their head.

Analysts at the Swiss bank Julius Baer have reassessed Sterling in the wake of a strong move higher this September as markets anticipate higher interest rates at the Bank of England.

For Sterling, the central driver of value are expectations surrounding the Bank of England.

The importance of the Bank of England and its impact on interest rates was noted by HSBC Bank plc who have recently informed clients they no longer see the Pound falling to parity with the Euro.

HSBC based their call for a fall to parity in the exchange rate on the assumption that other drivers - such as the current account deficit - would hold sway.

But, the incessant strangle of the Bank of England and interest rates on Sterling was underestimated.

Above: Brexit fears are playing second-fiddle when it comes to driving Sterling. What matters are interest rates and central bank policy.

And it is on this count that David A. Meier, Economist at Julius Baer says markets are making a mistake.

“Markets are buying into the BoE’s hints of a rate hike already in November. We remain cautious and believe that policy makers are talking up the pound to limit the inflation overshoot,” says Meier in a note dated September 19.

The economist argues if anything, an interest rate rise at the Bank of England seems like the wrong medicine.

“Given the potential for further Brexit-related uncertainty, we think that rate expectations could well be disappointed,” says Meier.

The Bank of England Has Done its Job

The Bank of England has apparently adopted a more aggressive tone on UK interest rates in order to put a lid on inflation.

The most recent set of inflation data from the ONS shows UK inflation knocking on the door of 3.0% - well above the 2.0% level targeted by the Bank.

One reasons inflation is running hot is owing to the fall in value in Sterling over the past year which in turn pushes the cost of imports higher. These rising costs are in turn passed on to consumers.

Therefore, by triggering a stronger Pound, the Bank can make some notable headway on capping inflation.

“The BoE can be proud of the currency markets’ reaction to its hawkish message at last week’s September policy meeting,” says Meier.

As a reaction, markets brought forward their rate expectations, with some believing in a hike already this November, pushing Sterling up to a two-month high at 1.1396.

But Julius Baer remain sceptical and think that the hawkish tone was set to stabilise the Pound instead.

“After Brexit jitters, such as the stalemate in the negotiations with the EU, recently rendered the pound weaker to EUR/GBP 0.92, policymakers had a clear incentive to aim for a more stable sterling – mission accomplished!” notes Meier.

Julius Baer note that “it is not domestic overheating that is causing inflation to surge – a rate hike at this point could be the wrong medicine.”

We would however note that core inflation - a measure of domestically generated inflation is also way above the 2.0% target at

We also note that further inflation from this source, which includes wage rises, appears set to grow further as UK unemployment continues to fall.

Indeed, as noted by the Bank of England’s Gertjan Vlieghe, “if near-term Labour market trends continue, expect upward pressure on medium-term inflation. There are some early signs of stronger consumption growth in Q3.”

Vlieghe’s has long been one of the more cautious members of the Bank of England’s policy-setting committee and he now believes an interest rate rise is warranted.

The Bank also believe that even after a 0.25% rate rise is implemented, lending conditions in the UK will be more accommodative than they were prior to the Bank’s August 2016 rate cut.

So the thinking is there is space to cut rates without jeopardising growth.

However, Meier is resolutely bearish on the Pound and the UK economy noting high inflation is curbing consumers’ purchasing power, “even more so as wage growth is still very sluggish despite the ostensibly low unemployment levels.”

“Together with the political uncertainty around the outcome of the Brexit negotiations, this is the most prominent headwind for UK economic growth. A rate hike might bring inflation down somewhat, but would put additional pressure on domestic demand,” says Meier.

What most economists can agree on is that an interest rate rise in November does not make for the start of a cycle of interest rate rises.

And cycles are what tend to deliver persistent currency gains.

Time for Markets to Sober Up on the Pound

Julius Baer are willing to reassess their negative stance on Sterling should data in coming weeks, in particular the October gross domestic product data for Q3, confirm the economy is picking up.

“Upside data surprises and signals of rising domestic inflation pressure would be necessary for us to change our view and expect a rate hike to materialise already this year,” says Meier.

The economist is also looking for an U-turn towards a softer Brexit by the UK government, a stance which would erode economic uncertainty and open the door for higher rates.

Prime Minister May’s speech on Friday could offer more information in that regard.

“Not expecting any shift in the Brexit stance, we believe that some sobering up of overly eager rate expectations will soften the currency later down the road. Therefore, we stick to our bearish GBP outlook,” says Meier.

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Two Interest Rate Rises say UBS

While Julius Baer suggest markets are getting ahead of themselves with regards to the potential for future interest rates, fellow Swiss banking group UBS have said they are forecasting not one, but two interest rate rises at the Bank of England in the near-future.

“Events last week lead us to conclude that only a more significant near-term deterioration in the data will now be enough to deflect them from raising rates in the near future,” says John Wraith, Strategist with UBS.

“Having now made the most explicit commitment since 2011 to near-term policy tightening, the MPC will be aware that to further alter their position, absent a sharp worsening of the outlook, would potentially impact its ability to influence market expectations in the future,” adds Wraith.

UBS forecast a 25bp rate hike in November and another in May 2018, taking Bank Rate to 0.75%.

But, beyond May, the prospect of further rate hikes are limited.

If correct we believe there is further upside for the Pound to be had as markets price in that second hike.