Likelihood of BoE rate cut jumps sharply

[Ben Graham]

The pound plunged, and the likelihood of a Bank of England rate cut rose sharply after the unemployment rate in the United Kingdom approached a five-year high and wage growth slowed. The unemployment rate rose to 5.2%, and pay growth decelerated.

This is a combination that materially undermined investor confidence in the British economy and triggered a sell-off in sterling. Economists had initially expected a lower unemployment reading, which had supported the view that the BoE would maintain a restrictive stance. Instead, the rise in unemployment to 5.2% and the slowing pace of wage growth point to disinflationary pressures that could weigh on economic growth.

Money markets now fully price a 50 bp reduction in the policy rate by year-end, implying a fall in the Bank Rate to 3.25%—the first cut in this easing cycle. At the start of the month, the probability of such a move had been around 50%.

The sharp fall in sterling and the prospect of lower rates have increased concerns about the near-term outlook for the UK economy. Labor market developments will be a key factor in the Bank of England's next actions and will materially affect the investment climate in Britain.

BBVA said that another cut next month looked increasingly likely and that the two cuts priced into markets for this year might prove insufficient given the macro picture in the UK.

Traders had already begun to price in deeper easing this month after the BoE missed cutting rates by a single vote at its last meeting. Governor Andrew Bailey backed market forecasts of easing shortly after that meeting, and today's data are likely to reassure policymakers that inflationary pressure in the labor market is easing quickly enough to allow rate reductions.

Tomorrow's UK inflation report will be closely watched for clues on the BoE's next steps. Economists expect headline CPI to slow to 3.0% year-on-year in January from 3.4%.

A technical outlook for GBP/USD suggests that buyers of the pound sterling should aim to reclaim the nearest resistance at 1.3600. That would open the way to test 1.3635, above which a breakout would be challenging. The extended target is around 1.3667. On the downside, bears will try to seize control at 1.3550. If they succeed, a break of that range would deal a serious blow to bullish positions and could push GBP/USD down to 1.3510 with scope to extend to 1.3470.

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