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A more-than-expected interest rate hike by the Bank of England provided only a brief boost to sterling on Thursday, as investors bet the central bank’s aggressive action could help tip Britain into recession later this year.
Sterling rose briefly after the Bank of England decided to raise borrowing costs to 5% from 4.5% previously. But the gains quickly faded, falling 0.1% to $1.2758 against the dollar, below where it was before the rate announcement.
The two-year UK government bond yield, which is sensitive to short-term rates, edged down to 5.03% from 5.06%.
Although relatively small, investors said the market was focusing on the dampening effect of higher interest rates on economic growth, upending the typical correlation between higher borrowing costs and stronger currencies. Further weakness in sterling has pushed up the cost of imported goods, which could cause headaches for the Bank of England as it tries to curb inflation.
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“The market is suggesting that this hike will kill growth and lower inflation, and I think the market is right,” said Mike Riddle, bond portfolio manager at Allianz Global Investors.
The rate hike follows the latest evidence of stubbornly high prices. UK inflation remained stuck at 8.7% in May, above expectations for 8.4%, according to data released on Wednesday.
Core inflation, which strips out volatile food and energy prices, rose again to 7.1% in May, the highest since March 1992, from 6.8% the previous month.
The data pushed sterling lower earlier this week, snapping a three-week winning streak against the dollar, even as traders bet the BoE would climb to 6 percent by year-end.
Tomasz Wieladek, chief European economist at T Rowe Price, said: “The idea that we can ease the heat in the labor market without slipping into a recession has never happened in UK history.”
“Everyone is really underestimating the impact of inflation on the UK economy – there is a possibility that the BoE will raise rates to 6% and the pound is still down,” he added.
The Bank of England was expected to raise rates by 0.25 percentage points ahead of Thursday’s decision, but markets were pricing in a 45% chance of a hike to 5% ahead of the meeting.
Jordan Rochester, currency strategist at Nomura, said a rate hike “could reduce the likelihood that further rate hikes will be needed later this year,” weakening the pound.