GBP/CAD tests 1.73 on BoE shockCould advance further short-termAs BoE rate assumptions surpriseBank Rate seen headed for 1.5%

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The Pound to Canadian exchange rate rallied sharply on Thursday after the Bank of England (BoE) lifted its benchmark interest rate before surprising the market with large upgrades to its forecasts for inflation and assumptions about the extent to which Bank Rate could rise over the coming year.

Sterling rose more than 100 points against the Canadian Dollar in the immediate aftermath of the BoE’s widely expected decision to lift Bank Rate from 0.25% to 0.50%, its second consecutive increase that reverses around two thirds of the reduction announced in early 2020.

More significantly for the market was the revelation that a significant majority of the nine member Monetary Policy Committee had favoured a larger 0.50% increase that would have taken Bank Rate up to 0.75%.

Even more significantly, the BoE announced sweeping upgrades to all but its longest-term inflation forecasts and indicated strongly that it could meet financial market expectations for lifting Bank Rate in the coming year, expectations which many observers had doubted it would be likely to endorse.

“Over and above the rise in interest rates from 0.25% to 0.50% and the start of unwinding QE, the Bank of England appears to have become more hawkish today. That supports our view rates will be raised to 1.25% this year compared to the rise to 0.75% expected by most economists. In fact, we’re increasingly thinking rates will need to rise above 1.25% in 2023,” says Paul Dales, chief UK economist at Capital Economics.

Above: GBP to CAD rate shown at hourly intervals alongside USD/CAD.

Reference rates at publication:

GBP to CAD spot: 1.7241High street bank rates (indicative): 1.6638 - 1.6758Payment specialist rates (indicative: 1.7086 - 1.7155Find out about specialist rates and service, hereSet up an exchange rate alert, hereIn addition, and apart from the main policy decision, the Bank of England also announced that it would begin the winding down of its £895BN bond portfolio acquired through the various quantitative easing programmes announced since the financial crisis.

“Four MPC members voted for a 50bp hike versus five preferring 25bp. This will suggest to the market that the BoE could hike faster and earlier compared to what was expected before, where gradual and modest have been the watchwords around policy tightening. In the near-term, this provides a somewhat more supportive backdrop for GBP,” says Dominic Bunning, European head of FX research at HSBC.

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The BoE’s newly updated forecasts suggested on Thursday that Bank Rate could be likely to rise to 1.5% by the early months of next year, which is roughly in line with implied measures of market expectations prevailing before the decision.

Thursday’s message comes after UK inflation reached 5.4% in December - almost three times the targeted two percent - and also follows further sharp increases in international energy costs that have threatened to prolong the period over which inflation remains above the desired level.

Above: GBP to CAD rate shown at daily intervals alongside GBP/USD.

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“The Bank also lifted its 2024 CPI inflation forecast to 2.15% (1.90% previously), suggesting that even with the extent of tightening already built into the curve, inflation would be above the 2.0% target in 2 years,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

That’s why the BoE has moved swiftly to withdraw the stimulus provided to the economy since the onset of the coronavirus crisis and is prepping companies, households and markets for further actions this year that would lift Bank Rate to its highest level since before the 2008 financial crisis.

However, the BoE’s longest-term forecast suggested inflation could be likely to fall below the 2% target by the opening quarter of 2025 in what is a potential indication that interest rates could be quick to come back down again at the other end of its hiking cycle.

“Effectively, the BoE is telling the market that the current profile (1y1m forward rate hit 1.67% at the time of writing) is potentially too aggressive and will lead to substantially below target inflation. This may make it harder for the BoE to deliver an overall tightening cycle that matches market expectations, creating a longer-term drag for GBP,” HSBC’s Bunning said in a note to clients on Thursday.