Image © Adobe Stock

The British Pound could experience a setback as the Bank of England will surprise investors by keeping interest rates on hold in early May, according to a leading investment and commercial bank.

"We think the risk of a pause at the current 4.25% Bank Rate is under-priced," says Chris Turner, Global Head of Markets and Regional Head of Research for UK & CEE at ING Bank N.V.

Money markets show investors are currently prepared for a further 25-50 basis points of interest rates from the Bank of England during the summer, which is at odds with ING's out-of-consensus expectation that the hiking cycle is now complete.

This matters for the interest rate-sensitive Pound which is 2023's top-performing currency, a development that has confounded the consensus amongst sell-side institutional analysts.

"We have been surprised by sterling strength in March. Given the UK’s large current account deficit and its large financial sector, we'd have thought it would have underperformed during the recent financial turmoil," says Turner.

The Pound's surprising rise comes as the bearish sentiment that clouded it at the start of the year is challenged by better-than-expected UK economic data which has prompted investors to bet on the likelihood of further Bank of England rate hikes.

This repricing of interest rate expectations can have a material impact on the Pound.

"The UK's double-digit rate of inflation suggests more pound-positive rate hikes are on the Bank of England's table," says Joe Manimbo, Senior FX Analyst at Convera.

An advance by the Pound to Dollar exchange rate is meanwhile a more substantive 3.0% for 2023, taking it to 1.2426 at the time of writing.

"We suspect that positioning may have played a role in sterling’s rally in March – where asset managers wrong-footed in bond markets also had to cover short sterling positions," says Turner.

A more balanced market positioning could mean the Pound is exposed to a reversal if incoming data disappoints and the Bank of England defies consensus expectations by keeping interest rates unchanged.

"A BoE pause should be a slight sterling negative," says Turner. "Assuming the ECB takes its own deposit rate (floor on overnight rates) to 4.00% in June, EUR/GBP should gravitate back to the 0.89 area."

ING forecasts the EUR/GBP exchange rate at 0.89 over a one to three month period ahead of a rise to 0.90 over a six to twelve-month period.

This gives a downward-sloping GBP/EUR forecast profile towards ~1.1236 and 1.11.

For GBP/USD, 1.21 is the one-month forecast, 1.24 is predicted for three months, 1.24 for six months and 1.28 in one year.

"Our base case is that GBP/USD may struggle to sustain a break above 1.25 this quarter – whilst the Fed is still in the last stages of tightening," says Turner.