Bank of England comments results in Sterling appreciation

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What's going on?

The Bank of England held a meeting discussing whether interest rates should change or not. All nine members of the meeting decided to keep interest rates at the current 0.5%. The minutes of the meeting did, however, result in an appreciation of the British Pound due to indications that future interest rates would rise more than previously expected.

What does this mean?

There is one comment in the meeting minutes that seems to have moved markets the most. The Bank of England (BoE) made a comment about the market yield on 2-year government bonds. Yield is the effective interest rate in the market if you buy a government bond. The BoE said they thought the yield on 2-year bonds was exceptionally low. According to the Financial Times, the yield prices in a 0.5% increase in interest rates over those two years. So effectively, the BoE told the market “Look, your expectations are wrong. We expect to increase interest rates by a fair bit more than 0.5% in that period”. Other comments in the minutes also made points in the same direction, that the BoE expects the economy to do well. The market didn’t fail to take their cue and adjust pricing. As per usual, higher interest rate expectations resulted in a higher currency. Higher interest rates naturally make it more attractive to move money to that currency.

Why should I care?

From an economic point of view, you might be relieved that the prospects for the UK economy are looking up. The UK has a significant role in the global economy and its path should therefore also be relevant to citizens outside of the UK. As an investor, you should focus on the mismatch between market expectations and the BoE expectations. Investing is all about taking a stance relative to expectations about the future. Expectations are often more important than the status quo. You might take the BoE’s expectations at face value and expect interest rates to rise. In this case, make sure your investments are protected against higher interest rates. Over-mortgaged houses or companies with excessive loans should be a concern to you. Interest rates that are locked in for the longer term could alleviate this concern. Alternatively you can take the view that the Bank of England will be unable to raise interest rates according to their expectations due to economic underperformance. In this case, you will do well to invest in government bonds or companies that make money regardless of the economic cycle.
Originally posted as part of the Finimize daily email.

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