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Sterling, Bond Yields Tumble on BOE Rate Rise -- Update

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11/02/2017 | 04:19pm CEST
By Christopher Whittall, Mike Bird and Riva Gold 

The pound slid sharply and bond yields fell after the Bank of England raised interest rates for the first time in over a decade but signaled that further increases weren't imminent.

The BOE's rate-setting committee voted by a margin of seven votes to two to raise its main policy rate from 0.25% to 0.5%.

Though widely expected, the move triggered a sharp market reaction, with sterling weakening and bond yields falling--shifts that are usually consistent with expectations that the central bank won't rush to raise interest rates further.

"The market response to the U.K. rate increase has been relief that the bank expects a very gradual hiking cycle," Mike Amey, head of sterling portfolios at Pacific Investment Management Co., said in a note.

The pound was trading down by 1.3% against the euro at EUR1.125 after the announcement, which will be the biggest one-day fall since January if the decline holds. Sterling fell 1.1% against the dollar to $1.31.

The yield on 10-year U.K. government debt fell around 0.07 percentage point to 1.27%, according to Tradeweb. Yields fall as prices rise.

Currencies typically decline when investors expect interest rates to remain low, as they shift their investments toward those that offer higher yields. Moves in bond yields tend to be heavily linked to short-term interest rates.

In its new statement, the Bank of England didn't reiterate its guidance from September that interest rates may need to rise by more than market participants expect. However, it said its outlook for inflation and economic activity were broadly similar to its last projections in August.

"The BOE has displayed quite a conservative outlook for the U.K. economy, " said Viraj Patel, foreign-exchange strategist at ING Bank.

He added that the pound was more likely to appreciate than fall from here.

"It doesn't seem like they're giving a ' one and done' signal on interest rates," Mr. Patel said. "From my point of view, I'll be buying this dip, basically."

Jordan Rochester, foreign exchange strategist at Nomura, also saw Thursday's decline in sterling as a short-term reaction. The U.K.'s negotiations over its exit from the European Union are seen as key across British markets.

"I don't really think this can be a new trend in sterling. I don't see how the Brexit negotiations can actually get worse than they were at the October meeting," he said.

The pound has been under pressure since the June 2016 Brexit vote and analysts believe Britain's negotiations and the political uncertainty around them have held sterling back.

Many investors believe those negotiations remain the pivotal factor, rather than the Bank of England, for whom Brexit has been key when making its decisions.

"There's so much uncertainty around where Brexit negotiations are going, " said Andrew Mulliner, a portfolio manager at Janus Henderson Investors.

"That's the dominant driver for U.K. risk at the moment," he added.

In stock markets, the FTSE 100 index--which generates roughly 68% of its revenues outside the U.K., according to FactSet--rose 0.4% in afternoon trading, leading gains among major developed equity markets.

A weaker currency tends to benefit multinationals as they translate revenue from overseas.

Some FTSE 100 companies that generate the greatest share of revenues overseas climbed after the announcement as the pound fell, with shares of British American Tobacco and pharmaceutical company Shire up 1.6% in afternoon trading.

Analysts are skeptical, however, that a weaker currency will support the FTSE 100 index for much longer.

"A recent return of U.K. inflation and, importantly, the onset of the first hiking cycle in 10 years, will likely lead to a dislocation in the negative relationship between sterling and U.K. equities," strategists at UBS wrote, noting currency-linked inflation can add to costs and hit local demand.

Smaller companies in the U.K. showed a more muted reaction to the bank's announcement, with the FTSE 250 index up 0.2% and the FTSE Small Cap Index up just 0.1%.

Shares of U.K.-focused lenders Royal Bank of Scotland Group and Lloyds Banking Group lagged behind, falling 1.2% and 1.4% respectively. A slower pace of rate increases could hurt banks' lending revenues.

British stocks remain unloved by international investors. The U.K. was the top underweight position held by global fund managers surveyed by Bank of America Merrill Lynch in October.

Write to Christopher Whittall at christopher.whittall@wsj.com, Mike Bird at Mike.Bird@wsj.com and Riva Gold at riva.gold@wsj.com

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