LONDON (Reuters) - Sterling jumped as much as 1.3 percent against the dollar on Thursday after the Bank of England said interest rates probably needed to rise sooner and by a bit more than it had previously thought because of the strength of the global economy.
Interest rate futures <0#FSS:> now project a 60 percent chance of a BoE rate hike in June and fully price in an increase in August meeting.
Before the BoE announcement, in which the bank also raised its UK economic forecasts, markets had priced in a 50 percent chance of a rate hike by May.
The central bank’s Monetary Policy Committee raised interest rates for the first time in a decade in November. The BoE voted unanimously to keep rates on hold at 0.5 percent on Thursday but Governor Mark Carney and colleagues saw a growing need to move faster on raising rates to keep a grip on inflation.
“This is a Brexit-contingent hawkish signal,” said Viraj Patel, an FX analyst at ING in London.
“The comment in itself was the surprise. That was a clear message from the bank that the (interest rate) curve was a little too flat for their liking.”
The pound rose to a day's high of $1.4067 GBP= after trading flat before the BoE announcement.
It later gave up much of those gains and was at $1.3942 at 1635 GMT as a broader sell-off in markets in late European trading hit sterling.
Against the euro, the pound rallied more than 1.2 percent, its best one-day performance in nearly five months, to a one-week high of 87.32 pence EURGBP= before falling back.
Britain's internationally exposed FTSE 100 .FTSE dropped to a session low and two-year government bond yields GB2YT=RR rose to their highest since late 2015.
Sterling has been one of the best performing currencies this year, rising to its highest levels since before the June 2016 vote to leave the European Union. Investors have focused on the surprising resilience of the UK economy and progress in Brexit negotiations, but the rally faltered in recent sessions.
Markets are now predicting central banks globally will tighten policy faster than previously expected with inflation expectations growing.
But the outlook for Britain has been overshadowed by the talks for Britain’s exit from the EU next year, and uncertainty over their future relationship.
Carney and colleagues said they now wanted to return inflation to its 2 percent target over “a more conventional horizon”, a sign they were turning their sights to tackling price growth over two years rather than three.
“Markets had moved quickly this year to discount more tightening from the BoE. The hawkish tilt of this meeting will at the very least vindicate these moves and possibly encourage further expectations,” said Michael Metcalfe, global head of macro strategy at State Street Global Markets.
“What will be key now is to watch how sterling responds, as a much quicker appreciation could produce a faster fall in inflation and potentially nullify the need for a more rapid tightening cycle.”
With the BoE’s comments contingent on a smooth exit from the EU next year, analysts also said sterling’s performance depended on the terms of Britain’s Brexit transition deal.
Sterling rose to a 16-month high of $1.4346 in January. It remains up 3.3 percent this year, but far below the plus-$1.50 levels before the Brexit vote.
Reporting Tommy Wilkes, Kit Rees and Andy Bruce; Editing by Janet Lawrence