BOE Preview: Bailey needs to go beyond a rate hike to boost GBP/USD on Super Thursday

• The Bank of England is set to raise rates from 0.25% to 0.50% n the first meeting of 2022.
• Higher inflation and Fed hawkishness back a move.
• Markets fully price in a move, necessitating more action to boost sterling.
• Signaling additional hikes, publishing robust forecasts and squeezing the balance sheet will be eyed. 

Will Andrew Bailey bail out the pound? The Governor of the Bank of England's words are set to be more important than his actions in the wake of the Federal Reserve's hawkish tilt. Markets will look beyond a near-certain second rate hike and compare the BOE's hawkishness with the tone from overseas. 

BOE Background

The BOE refrained from raising rates in November 2021, surprising markets, and then provided another shocker when announcing higher borrowing costs in December. Apart from seemingly sending confusing messages, investors were perplexed to see the BOE refrain from action when Governor Bailey had a press conference, and moving without an accompanying presser. 

The upcoming February meeting is another "Super Thursday," an event that includes not only a rate decision and the accompanying meeting minutes but also the bank's quarterly Monetary Policy Report, which includes updated economic forecasts. It is followed by a press conference by Bailey, which is more important than the rate hike. 

The governor earned the unflattering nickname "unreliable boyfriend" due to the surprises listed above, and now there is little room for a surprise on interest rates. Since the BOE hiked borrowing costs to 0.25% in December, economic data has continued showing improvement. 

Gross Domestic Product surprised with 0.9% growth in November, the unemployment rate dropped to 4.1% in November and inflation exceeded estimates with 5.4% in December. 

UK inflation has surpassed the post-financial crisis peaks:

Source: FXStreet

There is further cause to expect the MPC to raise lending rates by 25 basis points to 0.50% – central banks prefer acting in tandem and the US Federal Reserve's recent hawkish twist gives Bailey and Co permission to follow suit. 

Moreover, the recent drop in sterling's exchange rate means imports – which Britain depends on given its perennial trade deficit – become dearer, pushing inflation higher. By hiking, the BOE counters cost of imported goods, as well as cooling domestic demand. 

BOE Scenarios and GBP/USD reactions

As mentioned, a rate hike of 25bp is priced in, and if the BOE settles for only that action, GBP/USD could suffer a "buy the rumor, sell the fact" retreat. Therefore the pound will probably fall in the unlikely case that the BOE sits on its hands. 

What would move GBP/USD higher? A pledge to further raise borrowing costs would merely keep GBP/USD in place, however, Bailey would boost the pound if he opens the door to moving faster, at increments of 50 basis points – something the Fed has not ruled out. 

Given markets' skepticism of Bailey's roadmap signing on rates, it would be wiser to focus on a potential squeeze to the balance sheet. The BOE's Asset Purchase Facility ballooned to £895 billion in the aftermath of the pandemic, and its latest expansion expired late in 2021. 

Source: BOE

If Bailey announces a gradual squeeze of the BOE\s balance sheet, sterling would advance. A natural runoff, refraining from reinvestments of maturing bonds, would have a minor positive impact, while an active sale of British debt would already pull money out of markets, boosting the pound's value. 

The governor and his colleagues might refrain from details at this point, but rather follow the Fed's footsteps and provide general guidance. That would also support sterling, albeit in a limited fashion. 

Last but not least, the BOE's updated forecasts would be of interest. If they point to significantly stronger inflation, it would imply more aggressive action from the BOE. The higher the projected price rises, the higher the pound could go. 

Latest BOE fan chart:

Source: BOE

Final Thoughts

The BOE is set to raise rates by 25bp on February 3, and that would be insufficient to keep sterling higher. A mix of pledges to further hike borrowing costs, squeeze the balance sheet and forecast higher inflation would be needed to boost GBP/USD.