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LONDON (Reuters) - Sterling's recent gains on a spike in market-driven short-term interest rates and a rise in British gilt yields to two-year highs could be at risk if, as some expect, the Bank of England voices concern over short-term rates.
Some investors expect BoE Governor Mark Carney to intervene verbally next week in a bid to ease financial conditions, which have tightened due to higher overnight rates. That could see the pound give up some of its recent gains, and option markets indicate the pound could become more volatile.
Carney is due to speak on August 28 in the city of Nottingham and some in markets believe he will use the occasion to try to reverse the rise in rates, which runs contrary to the BoE's guidance that interest rates are likely to stay at record lows for three more years.
"The BoE's forward guidance is backfiring," said Adam Myers, head of European FX strategy at Credit Agricole. "We expect the BoE to soon talk down interest rates, and that could have an impact on sterling."
A rise in yields, both short- and long-term, makes a currency attractive for global investors seeking higher returns.
That has seen trade-weighted sterling soar to a seven-month high, and a sustained rise could threaten exports. The pound has risen 3 percent this month to levels around $1.5660, while against the euro it is at 1-1/2 month high at 85.30 pence per euro.
Rates have risen largely because markets doubt that, with data signalling a recovery is under way and stubborn price pressures, the BoE will be able to keep rates anchored for the three years suggested by its forward guidance.
Sterling overnight interest rates (SONIA) are beginning to price in an implied rise in the bank rate from the current 0.5 percent as early as February 2015.
The 18-month SONIA rate, which stood at 0.4700 a week ago, is inching towards 0.5000 which would imply a BoE move in early 2015. The two-year SONIA rose to 0.5650 percent from 0.4025 percent at the start of the month, pricing in a greater chance of a rate hike in August 2015.
"Tightening conditions would not be welcomed by the BoE," said Kenneth Dickson, investment director at Standard Life, which has $271 billion (£173 billion) of assets under management.
"They would not want market rates to move higher and hence Carney would want to make his presence felt in the shorter and longer end of the curve. And he will choose to address the rates market rather than the currency."
It would not be Carney's first intervention since becoming BoE chief, so investors betting on more gains in sterling will be cautious.
Just days into his new job, on July 4, he issued a statement after a regular monthly policy meeting that a rise in domestic bond yields, caused primarily by expectations the Federal Reserve may withdraw stimulus, was "not warranted".
That saw yields drop and sterling tumble to a three-year low of $1.4814, shedding 3 percent in four trading sessions.
But yields have since risen again with the 10-year at a two-year high and SONIA rates are back at where they were in late June, just before Carney took over as governor.
Analysts say a drop in yields across the curve would reduce sterling's attractiveness. In the options market, one-week implied volatility, a measure of expected price swings, rose to 6.65 percent from 6.37 percent on Monday.
"With UK short rates likely to remain low in the year ahead once the current investor excitement cools down, recent pound strength is unlikely to prove unsustainable," said Lee Hardman, currency analyst at Bank of Tokyo Mitsubishi.
Editing by Nigel Stephenson