Image © Pound Sterling Live

Investors now anticipate the Bank of England to raise interest rates to as high as 4.5% following a recent run of strong economic data, a development that could offer the Pound ongoing support say currency analysts.

The UK OIS market - a money market that reveals how the market is positioned for future interest rates - now shows investors expect a higher peak in Bank Rate of around 4.58% by September as a result of the recent data.

"Stronger than expected UK data this week was seen buying the Bank of England more time to raise rates to tame double-digit inflation. Evidence of a resilient British economy also suggested the BOE might be able to pull a page out of the Fed’s playbook of keeping interest rates higher for longer," says Joe Manimbo, Senior Analysts at Convera.

The Pound lost value against both the Euro and Dollar in February but a turning point might have been reached following a recent run of better-than-expected data that prompted investors to raise expectations for where the Bank of England will end its interest rate hiking cycle.

Rising expectations for the peak in Bank Rate in turn lifted UK bond yields, which serves as a mechanism for a higher Pound.

A sharp lift in expectations for the peak in Bank Rate came after UK PMI survey data for February showed a strong rebound in UK economic activity, with the Composite PMI reading at 53 (above 50 signifies expansion), exceeding the pace of improvement seen in the Eurozone and U.S.

"Despite the global environment, GBP was the (fairly unusual) winner during yesterday's session with EUR/GBP edging back below 0.88 for the first time since January. The move follows stronger-than-expected preliminary PMI's for February," says Kristoffer Kjær Lomholt, Director, FX and Rates Strategy at Danske Bank.

Should the economy return to growth in February and over the coming months the prospect of inflation remaining elevated for longer increases, thereby pressuring the Bank of England to deliver at least two more interest rate hikes before pressing the pause button.

Above: Expectations for the peak in Bank Rate have risen through February according to money markets. Image courtesy of Goldman Sachs.

A rise in Bank Rate to 4.50% suggests at least two more 25 basis point rate hikes are expected from the bank of England, as opposed to pricing at the start of the month that leant towards a final hike in March.

Expectations for the peak in Bank Rate rose by nearly 20bp alone on Tuesday, as a result of the surprisingly strong PMI release, propelling the Pound higher.

The Pound to Euro exchange rate rose 0.94% on the day to 1.1375, before paring gains to 1.1354 at the time of writing.

The shift in spot takes transfer rates at typical high-street banks to 1.0960-1.1130, holiday money and cash rates at competitive providers to around 1.1241 and competitive money transfer rates to around 1.1320.

The outlook for the Pound, therefore, rests to a great degree on whether expectations for further interest rate hikes and elevated relative UK bond yields can be maintained.

Should expectations be maintained by incoming data and Bank of England communications then Pound exchange rates can defend recent gains (provided the global investment environment doesn't deteriorate materially).

Above: "UK rebounds from peak pessimism, edging past Eurozone?" - Westpac.

"The combination is providing a floor for GBP, notably against EUR. The PMI charts against EUR/GBP (inverted scale) show that GBP tends to rise when the PMIs are in expansionary territory and when UK PMIs are above EZ PMIs," says Richard Franulovich, a strategist at Westpac.

But analysts at Commerzbank warn of the potential for investor disappointment on this front, as the Bank of England could disappoint by failing to deliver two more 25bp hikes.

"It runs the risk of ending its fight against inflation too soon and inflation becoming a more persistent problem. This risk is likely to weigh on the pound in the coming months," says You-Na Park-Heger,

FX Analyst at Commerzbank.

Commerzbank's economists expect another rate hike in March of 25bp to 4.25%, putting them below the market's signal that investors are looking for a further 50bp.

"The market has priced in a bit more. We therefore see potential for disappointment, which should weigh on the pound. The ongoing concern that the BoE could fall behind the curve with its cautious approach also argues for weaker pound levels, in our opinion," says Park-Heger.

Incoming data meanwhile leads Danske Bank to expect a further decline in headline inflation which acts as a clear positive for the UK economy, underscoring their relatively constructive view of the UK currency.

Danske is targetting EUR/GBP at 0.85 in 6-12 months, giving a GBP/EUR rate of 1.1765.

This contrasts with Commerzbank's forecasts for EUR/GBP to trade at 0.90 (GBP/EUR @ 1.11) in three months and 0.91 (GBP/EUR @ 1.10) in six months.