Unicredit Tower A, Milan © Sergio Fabio Brivio, Flickr
Bank of England will cut rates faster than expected, warns UniCredit.
The market is underestimating how far and fast the Bank of England will cut interest rates, which will weigh materially on the pound to euro exchange rate, says a leading global investment bank.
"We see more and faster rate cuts than markets," says Daniel Vernazza, Chief International Economist at UniCredit in London.
The market is currently anticipating two more reductions in Bank Rate during this cycle, taking it to 3.5%.
This expectation was reinforced by Thursday's decision to leave interest rates unchanged at 4.0% but signal in clear terms that another cut was imminent. Most economists think the tone adopted by the Bank points to a cut at December's meeting.
However, UniCredit expects the labour market to continue to weaken and consumption growth to remain soft, reinforced by the likely material tightening of fiscal policy in the upcoming Autumn Budget.
The government looks all but set to raise the basic rate of income tax for the first time since the 1970s, which economists say will squeeze the economy and pressure inflation.
"Inflation should move down to 2% next year. In this environment, we expect the MPC to cut rates in December, followed by a quarterly pace of rate cuts next year to 2.75%," says Vernazza.
The Bank of England's November Monetary Policy Report revealed forecasts showing it expects inflation to fall back to the 2.0% target much later, in late 2027.
The Bank's latest forecasts also show it is modelling the economic outlook on the market's assumption that Bank Rate will fall to a terminal rate at 3.5% next year.
Foreign exchange markets are responsive to interest rate expectations, meaning the pound would decline in the event that the market adjusts to UniCredit's thinking on inflation and the more aggressive path of cuts that the Bank of England would respond with.
If the Milan-based lender is correct, a significant repricing in market interest rate expectations awaits, which will drag materially on the pound.
Given this, UniCredit holds a pound to euro forecast of 1.11, which is well below the consensus of predictions made by its peer investment banks.
Above: 1.11 is the bottom of a long-term range for GBP/EUR.