Pound firms on prospects for more aggressive rate rises

Goldman Sachs sees back-to-back interest rate rises that would take rates to 1% in May. Craig Inches, portfolio manager at Royal London Asset Management, said markets might not be prepared for the possibility of a more hawkish BoE, especially as balance sheet shrinkage unleashes more bond supply. "If they move interest rates to 0.5%, the market will expect them to announce they won't be reinvesting the proceeds of the March 2022 gilts ....

(Updates prices, adds quote, chart) By Sujata Rao

LONDON, Jan 31 - Sterling touched 23-month highs against the euro on Monday at the start of a week where the Bank of England is expected to raise interest rates for the second time in as many months. The currency gave up some of its gains after news that Prime Minister Boris Johnson will make statement to parliament at 1530 GMT on a report into alleged parties at his office and residence during COVID lockdowns.

By 1230 GMT, the pound was flat versus the dollar at $1.34, having earlier risen as high as $1.3458 but staying above one-month lows of $1.3359 hit last week. Sterling also flatlined against the euro after hitting 83.05 pence, its highest since mid-Feb 2020 .

The British currency is set to end January with a loss against the dollar, which has benefited from the rapid ramping up of Fed rate hike bets. Against the euro it is up more than 1% this month . Most economists polled by Reuters expect the BoE PREVIEW-Bank of England on track for second rate rise in under two monthsto raise rates to 0.5% on Feb. 3 from 0.25%. Reaching the 0.5% threshold would also see the bank stop reinvesting maturing gilts and start to reduce its 875 billion-pound government bond holdings.

But some predict a more hawkish stance. Goldman Sachs sees back-to-back interest rate rises that would take rates to 1% in May. Craig Inches, portfolio manager at Royal London Asset Management, said markets might not be prepared for the possibility of a more hawkish BoE, especially as balance sheet shrinkage unleashes more bond supply.

"If they move interest rates to 0.5%, the market will expect them to announce they won't be reinvesting the proceeds of the March 2022 gilts .... that will be the first sign we see of how markets react to balance sheet reduction," Inches said. He also said that while the market was pricing terminal rates - where rates may peak - of just above 1%, the effect of Brexit on labour costs could push that much higher.

Money markets are pricing rates at 1.25% by year-end HSBC highlighted risks the BoE would flag even higher inflation ahead, or signal actively cutting its balance sheet, rather than just allow maturing gilts to roll off.

"If the terminal rate were to be adjusted much higher, due to either of the above forces, it would provide more ammunition for rate hikes and would create a less negative backdrop for sterling," HSBC told clients. Risks to headline inflation could come from a 50% jump in energy bills from April but the government has balked at cutting value-added tax on consumer energy costs.

Several BoE policymakers have commented on inflation risks in recent weeks, with governor Andrew Bailey https://www.reuters.com/world/uk/boes-bailey-sees-risk-uk-inflation-pressures-will-linger-2022-01-19 suggesting the risk of second-round inflation effects was a source of concern and that the bank would do "everything we can do".