The Bank of England’s first rate rise since 2023, and its signal that more could follow, should keep the pound supported into 2027, although against the dollar the picture is complicated by turmoil in AI stocks.
The Bank of England raised Bank Rate to 4% on 5 November, its first increase since August 2023, as higher energy prices linked to the conflict in the Middle East push UK inflation higher.
The Bank expects inflation to rise from 3.5% in September to around 5% by the middle of 2027.
Every member of the Monetary Policy Committee backed tighter policy, with Catherine Mann voting for a larger half-point rise.
Governor Andrew Bailey said the rise is unlikely to be the last unless the conflict in the Middle East is resolved, although he stressed it should not be seen as the start of an “inevitable long sequence of hikes”.
The decision keeps UK interest rates among the highest of the major economies, which supports the pound.
UK interest rates keep the pound among the highest-yielding major currencies
Bank Rate at 4% stands above the European Central Bank’s (ECB) 2.50% deposit rate and at the top of the Federal Reserve’s (Fed) 3.75% to 4.00% target range, after both central banks raised rates in September.
Higher Bank Rate in turn holds the returns on British interest-bearing products, from savings and money-market funds to short-dated government bonds, above those in most comparable countries, drawing a flow of capital into the UK that bolsters sterling.
“Stronger-than-expected UK growth and the prospect of further tightening should remain supportive for GBP heading into year-end,” says Henry Cook, Senior Economist at MUFG.
The euro faces additional pressures due to France, where the struggle to pass the 2027 budget has pushed government borrowing costs sharply higher.
“The contrast between the UK’s fiscal discipline and the political & fiscal upheaval in France remains a key support for the GBP vs EUR,” says Valentin Marinov, Head of G10 FX Strategy at Crédit Agricole.
Businesses buying euros are dealing near the top of the range the pound has held since 2016, although sterling’s higher interest rates mean euros bought forward cost more than at spot.
Markets expect more UK rate rises than economists do
Money markets – namely Overnight Index Swaps – show investors are pricing Bank Rate rising to around 4.75% in the third quarter of 2027, against expected peaks of around 4.50% for the Fed and 3% for the ECB.
However, investment bank economists see a lower peak for UK rates, “with signs of second-round effects remaining minimal at this juncture, we retain our view for one more hike with Bank Rate peaking at 4.25%,” says Sanjay Raja, Chief UK Economist at Deutsche Bank.
Exchange rates respond to shifts in interest rate expectations, so the pound would come under pressure as investors pare back their bets towards economists’ forecasts, although a peak of 4.25% would still leave UK rates well above those in the euro area.
Rob Wood, Chief UK Economist at Pantheon Macroeconomics, sits at the higher end of forecasts with two further rises to 4.50%, and argues the Bank’s guidance has opened the risk of more.
The Bank itself regards part of the market’s pricing as protection against the Middle East conflict, “recognising that some of the upward slope in the curve is explained by risk premia and not expected rates, the current level of restrictiveness is broadly appropriate,” says Governor Bailey.
“Market pricing in general still looks too aggressive to us,” says Matthew Ryan, Head of Market Strategy at Ebury.
The Bank’s next steps depend on energy prices
Energy prices will decide how far the Bank raises rates, and with it how much support the pound keeps.
“In the absence of evidence of weaker inflation pressures, there is likely to be a case for a further increase in rates in the near term,” says Clare Lombardelli, Deputy Governor for Monetary Policy at the Bank of England.
UK businesses have so far been shielded from much of the rise in energy costs, with the Bank’s regional Agents reporting greater use of fixed-price contracts and hedging arrangements than ahead of the 2022 energy shock.
“Energy hedging or longer-term fixed price contracts have helped many firms for now, but their buffers could prove temporary,” says Mathias Van der Jeugt, Analyst at KBC.
The Bank is watching whether the shock spreads into wages and prices, “any signs of broader spillovers could quickly turn an insurance hike into a fuller hiking cycle,” says Deutsche Bank’s Raja.
However, most chief financial officers told the Bank’s October Decision Maker Panel they cannot raise prices enough to protect their margins from higher energy costs, a sign that demand may already be faltering.
“If that is right and energy prices recede, the BoE will not follow through with the second hike it threatened today,” says Andrew Wishart, Economist at Berenberg.
Energy prices could fall faster than futures markets suggest if the conflict in the Middle East reaches a lasting resolution, says the Bank.
The Bank also sets out a “weaker demand” scenario, in which households and businesses cut back in the face of high energy bills and a less restrictive policy stance is needed.
In either case, the pound would lose part of its rate support, although UK rates would still sit above those in the euro area.
Corporate borrowers would see that shift first in bond markets, where yields have risen with market rates, while rates on new bank lending to companies have stayed largely flat since July because they track Bank Rate, says the Bank.
Stock market turmoil weighs on the pound against the dollar
Against the dollar, the pound is more exposed to global stock markets than to the Bank of England, after the Democrats’ sweep of Congress in the 3 November midterm elections raised fears that AI investment will be curbed.
US technology shares fell sharply in response, with the Nasdaq 100 suffering its worst day since March 2020 on 5 November.
“The deepening sell-off in AI-related tech stocks could dampen upside for UK rates and the GBP,” says MUFG’s Cook.
UK and US interest rates are expected to peak within a quarter of a percentage point of each other, suggesting rates will do less to separate the two currencies than shifts in risk appetite.
Investors tend to buy dollars when stock markets fall, which leaves the pound vulnerable for as long as the turmoil lasts.
However, the dollar could weaken over the longer term if the AI boom slows, with Crédit Agricole’s Marinov expecting a less aggressive Fed and buckling tech stocks to undermine the US currency into 2027.
Treasurers with dollar exposures face a pound driven by swings in stock markets in the near term.
Over the longer term, sterling’s prospects against the dollar depend on how far a slowdown in AI investment lowers US interest rates.