GBP: Bank of England’s Brexit risk premium

• GBP's circa 1% knee-jerk move
We attribute the pound’s circa 1% knee-jerk move lower, to markets pushing back their expectations for additional Bank of England rate hikes. Although the overall level of tightening priced in has returned back to where it had been on average over October. The market-implied BoE policy rate in three years’ time is now at 1.00% - which we deem appropriate relative to BoE’s message today.

• The binary ‘Deal or No Deal’ Brexit risks
The binary ‘Deal or No Deal’ Brexit risks makes it understandable as to why this may have been initially perceived as a one-and-done type of reaction – even though the Bank’s official guidance gave nothing to this sort. The Bank’s fairly laissez-faire forward guidance, in fact, retains an element of policy flexibility.

• Debates over the timing of the next rate hike
The debates might continue to give us some small movements in GBP over the near-term but these are just semantics for the broader outlook for GBP. When it comes to BoE policy, the bigger driver tends to be the overall level of tightening priced in over the two or three-year part of the curve (see Fig 2 below) – and this remains data, and more importantly, Brexit-dependent.

• We see upside risks here based on our assumptions for Brexit negotiations
Here our motto is ‘small steps are way better than no steps’. We see progressive steps agreed Brexit transition deal as providing cyclical support to GBP – in particular it would reduce some the medium-term uncertainty keeping economic activity on hold, allowing potential upside revisions to 2018/2019 UK GDP growth and in the context of the BoE – this would add a couple of rate hikes to our tightening cycle assumptions.

•Bottom line
We continue to see upside risks to sterling with the 'Carney put' now in place. Speculation of additional Bank rate hikes will continue to act as a buffer to the currency. Plus – with the Bank retaining its optimism over wage growth dynamics and underlying inflationary pressures – we think markets may be underestimating the role of the pound in the Bank’s policy thinking.

In particular, the November Inflation Report acknowledges there are still some lagged inflationary effects yet to feed through from GBP’s post-Brexit depreciation – and this is proving to manifest, slower than anticipated.