The pound will lose interest rate edge

Interest rate trends will inevitably be important for Sterling, especially with further market speculation over aggressive Bank of England rate cuts. At the June Monetary policy meeting, two members of the nine-person committee called for a rate cut and, although rates were left on hold in July, markets are expecting at least two rate cuts over the remainder of 2005.

The BOE is likely to be cautious, especially as there will be fears over inflationary pressure resulting from high energy prices and the weaker currency. Input prices at the producer level rose at the fastest annual rate in more than 20 years in June with further strong rises probable for July. The consumer inflation rate also increased from 1.9 percent to the 2.0 percent target level in June.

U.S. interest rates are likely to rise further over the next two months and it is certainly possible UK rates could fall to meet U.S. rates at around 4.0 percent by early 2006. (The U.S. Federal Reserve pushed U.S. rates to 3.25 percent at the end of June and is likely to increase rates to 3.5 percent in August.) Although it is more likely the pound will retain a small premium vs. the U.S. dollar, there will definitely be reduced interest rate support.

UK interest rates were more than 3.5 percent higher than U.S. rates 12 months ago, and a substantial narrowing of the yield gap would pose a very tough test for the pound confidence. As mentioned, Sterling is traditionally vulnerable to big moves when there is a decisive shift in confidence.

The U.S. economic data has remained firm, but there will be considerable risks associated with high oil prices. The U.S. economy could slow later in the third quarter and the Fed is likely to consider a pause in the tightening process after its September or November meetings. If there is a pause and U.S. rates appear to have peaked, the pound will be much less vulnerable to selling pressure.