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Rallying pound may be vulnerable to BoE warning shot

Anirban Nag
Wednesday, 4 Dec 2013 | 10:55 AM ET

LONDON, Dec 4 (Reuters) - Sterling's rally to five-year highs against a basket of currencies on robust UK data could raise the risk of verbal intervention by the Bank of England, which wants to shift the economy towards more exports.

Any sign that the BoE is becoming uncomfortable with the strength of the currency would see the pound give up some of the strong gains it has made in the second half of the year.

It fell on Wednesday after data showed Britain's services sector expanded at a slightly slower pace in November and as the U.S. private sector added more jobs than expected, lifting the dollar. But traders said sterling buyers emerged on dips.

The BoE's Monetary Policy Committee began a two-day meeting on Wednesday with no change to policy expected. But sterling's strength and its potential to hurt the recovery and a shift towards more exports may be discussed, some analysts said.

A stronger pound, which has risen on expectations that the BoE could be among the first major central banks to tighten policy, makes exports more expensive and can hurt growth.

Some major central banks, including the Bank of Japan and the Reserve Bank of Australia have flagged concerns about the strength of their currencies, driving down their value.

While the chance of the BoE stepping in immediately are seen as low, analysts say it may not stay silent forever.

"As the BoE's strategy is all about securing the strongest recovery possible whilst it can, then the pound is no longer doing it any favours," said Neil Mellor, currency strategist at BNY Mellon. "The sooner it draws attention to the incongruity of such a stellar pound performance, the better."

The trade-weighted sterling index hit a five-year high of 85.1 on Tuesday. The pound has gained more than 10 percent against the dollar since striking a three-year low of $1.4814 on July 9.

It traded at $1.6350 on Wednesday, having hit a two-year high of $1.6443 and an 11-month high against the euro on Monday.

It has also gained 20 percent against the lower-yielding yen this year as economic recovery took root, raising expectations the BoE will tighten policy earlier than flagged.

Indeed, 10-year UK gilt yields on Wednesday hit their highest since late September at 2.907 percent, driving the spread over German Bunds to near their widest in 8 years.

LID ON INFLATION

In forward guidance unveiled in August, the BoE said it would keep interest rates low until unemployment fell to 7 percent - something it expected to happen in late 2016. It has since said the jobless rate could fall below 7 percent sooner, but that it still intends to keep policy ultra-loose.

A stronger pound helps drive down the cost of imports and should keep a lid on inflationary pressures. That will help the BoE keep interest rates low for longer.

Annual inflation in Britain is hovering just above the BoE's target of 2 percent and some traders say this is one reason why the BoE could tolerate a higher pound.

"Britain is still one of the few G-10 economies that has above-target inflation. A firmer pound will keep a lid on that," said Chris Turner, chief currency strategist at ING.

"And while we acknowledge that a firmer pound can put the rebalancing of the economy at risk, I do not think that the BoE would want to show any discomfiture just yet."

So far, a firm pound has had little impact on economic activity. Manufacturing and construction purchasing managers' indexes have added to optimism about a UK recovery.

"A stronger pound won't threaten the UK's now well-established recovery," said Savvas Savouri, chief economist at hedge fund firm Toscafund, adding Britain's high-quality exports were not sensitive to currency moves.

Nevertheless, some BoE policymakers have expressed concern, but traders said that unless Governor Mark Carney steps in, sterling bulls are unlikely to be shaken.

Samuel Tombs, an economist at Capital Economics, says the BoE may step in soon. He said the rise in the pound has increased the chances that inflation falls significantly below the 2 percent target next year and threatens rebalancing.

"As a result, the MPC may begin to consider ways to weaken sterling again. Merely expressing concern about sterling's strength earlier this year caused it to fall," he said.