Sterling hits 2-year high as rate cut hopes cool

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Sterling hit its highest level against the dollar since March 2022 on Tuesday as investors prepare for the US Federal Reserve to start lowering rates more quickly than the UK’s central bank.

The pound rose as much as 0.4 per to $1.3246 after the top central bankers set out differing outlooks for interest rates in the US and UK late last week. Sterling later fell back to trade up 0.3 per cent at $132.28, but the gains kept the currency on track for its best monthly performance against the dollar since November.

At a conference in the US, Fed chair Jay Powell said the “time has come” for US rate cuts, but Andrew Bailey, governor of the Bank of England, warned it was “too early to declare victory over inflation” in Britain.

“The stark contrast between Powell’s rate cut greenlight and Bailey’s more cautious stance on Jackson Hole is a good summary for what is underpinning the pound’s strength,” said Kyle Chapman, a forex analyst at currency brokerage Ballinger Group, referring to last week’s summit in the US.

Sterling has been supported by stronger than predicted economic data in recent months, and optimism that the new Labour government will usher in a period of political stability and growth-enhancing planning reforms.  

UK private sector activity grew faster than expected in August, its highest pace in four months. Economic growth of 0.6 per cent in the second quarter was also “well above” market expectations, according to Derek Halpenny, head of research at MUFG.

However services inflation, which is closely followed by the BoE for signs of underlying price pressures, remains stubbornly above 5 per cent. UK annual salary increases are also “not pointing to any urgency in favour of easing”, said Geoff Yu, foreign exchange strategist at BNY.

UK wage growth slowed to the lowest rate in almost two years in the three months to June at 5.4 per cent, but the unemployment rate unexpectedly fell, signalling resilience in the labour market.

The uncertain outlook for the UK economy split BoE policymakers when they delivered their first interest rate cut for more than four years at the start of August. Traders are betting on a percentage point worth of cuts from the BoE by the middle of next year.

By contrast investors expect the Fed to deliver seven or eight quarter-point interest rate cuts by the middle of the next year, with traders split on whether the first cut next month will be 0.25 or half a percentage point.

Bailey offered some encouraging news on the outlook for UK inflation on Friday as second round inflation effects “appear to be smaller than expected”.

Analysts said US payrolls data in early September would be key for the dollar’s performance, as a weak report could prompt traders to bet on a hard landing in the US and faster rate cuts from the Fed.

“There was plenty in Bailey’s speech to indicate that the BoE are becoming more optimistic and they are less concerned about inflation persistence . . . but coming after Powell’s speech it felt hawkish and indicates the potential divergence going forward,” said MUFG’s Halpenny.