Bank of England to go 25bp ThursdayCIBC looks for soft inflation forecastsSays EUR/GBP upside favoured

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The Bank of England is widely expected to raise interest rates by 50 basis points on Thursday, but analysts at one international investment bank say the hike will be smaller, and a weaker British Pound will be the result.

CIBC Capital Markets - the investment banking arm of Canada's CIBC - says its Bank of England call is for a 25bp hike this week.

"That’s in contrast to the street, which is expecting 50bps," says Bipan Rai, Head of FX Strategy at CIBC Capital Markets. "If we’re correct, then watch for the GBP to fall."

The Bank of England hiked interest rates through the course of 2022 and the Pound traded lower in the aftermath of the majority of the decisions, confirming a trend that might yet extend into 2023.

The Pound's weakness was because either, 1) the Bank raised interest rates by a size smaller than the consensus expected, or 2) they met expectations on the size of the hike but offered pessimistic guidance and soft economic forecasts.

"The reason for our non-consensus call is that after a VERY aggressive year of tightening, the BoE is likely to place greater weight on the impact of prior hikes," says Rai.

CIBC expects the Bank will want to slow down to consider the impact previous hikes will have on mortgages, particularly as a significant amount of fixed-rate mortgages will soon fall due for renewal.

"Additionally, there's a very good chance that the Bank will revise its longer-term inflation projections lower," says Rai.

The Pound to Euro exchange rate started the new week under pressure at 1.1370 and the Bank of England's decision and guidance will be pitted against that of the European Central Bank, which is also expected to deliver a 50bp hike on Thursday.

The Pound to Dollar exchange rate meanwhile contends with the Federal Reserve's decision on Wednesday night, where a smaller 25bp hike is expected.

Therefore the outlook for the Pound will this week depend on the decisions of no less than three central banks.

Above: GBP/EUR (top) and GBP/USD showing recent price action and the impact (purple arrow) of December's characteristically dovish Bank of England event. Consider setting a free FX rate alert here to better time your payment requirements.

For the Pound, the risk is all three deliver what was expected of them on the rates front but the Bank of England diverges with more downbeat guidance on the outlook.

The Bank will likely raise its 2022 economic forecasts but beyond that, the economic projections will likely remain gloomy.

What happens to the inflation forecast is of particular concern.

"We would view the prospect of collapsing real economy data and a likely CPI undershoot, from Q2 2024 onwards, as likely maintaining a strong policy fissure across the MPC," says Jeremy Stretch, CIBC's Head of G10 FX Strategy.

CIBC expects another three-way vote split on the Bank's Monetary Policy Committee, culminating in a 25bp hike rather than the 50bps discounted by analysts, and the market.

"A less aggressive BoE... points towards anticipating a correction in the Sterling strip. We would also look to play Sterling from the short side," says Stretch.

CIBC's preference is to play "this out via EUR/GBP upside".

The ECB surprised markets and boosted the Euro in December by warning it would need to raise interest rates by more than the market was expecting at the time, given fears that inflation would prove persistent.

These fears will not have been assuaged by data from Spain on Monday that showed inflation had actually increased in the year to January.

Inflation in Spain rose 5.8% year-on-year in January, surpassing the previous month's 5.7% and trouncing the market's expected forecast of 4.9%. The HICP measure rose to 5.8% from 5.5% a month prior, core inflation rose 7.5%, said the INE.

Spain has been routinely seen as a 'bellwether' for broader Eurozone inflation with a lead of about two months, therefore the figures send a warning to the ECB's Governing Council that more work needs to be done on interest rates.

Following the Spanish inflation reading money markets promptly added 5 basis points to the expected peak of the ECB's basic rate and the Euro rose in response.

"The increase in headline inflation ends five straight months of decline and core shot up to a new high of 7.5%. This obviously runs against the thesis that the worst for inflation in the euro zone has passed and will only strengthen the hand of the hawks on the ECB governing council who last week repeated the case for 50bp at the next few meetings," says Kenneth Broux, a strategist at Société Générale.

The Euro therefore could be well supported against the Pound, particularly if the Bank of England serves up its characteristically dovish dose of caution.