Interest rate rumors gather pace

Sterling rallied heavily against both the dollar and euro yesterday as expectations that the Bank of England will now start to raise interest rates by mid-2011 and the general uptick in risk appetite kept the dollar under pressure.

Implied interest rate futures based on overnight index swaps were pricing in nearly a 70% chance of a 25 basis point rate rise in May, up around 40% form last weeks predictions.

Expectations for higher UK interest rates have been set since inflation data last month overshot expectations and has fed into the pound’s rally against the dollar this year.

Sterling got a boost on Tuesday after strong manufacturing sector PMI numbers. It has also been bolstered by increasingly hawkish comments from policy makers including Andrew Sentence who said the longer the central bank delays taking action against rising inflation the bigger the threat to its credibility.

Deputy Governor Charles Bean also weighed in and was quoted as saying that the central bank would need to act on interest rates if commodity prices continue to rise and inflation becomes embedded.

The environmental impact of the floods in Australia has been well publicised throughout 2011 so far, and the Australian dollar rate has also changed in-line with the rising water, with the dollar losing nearly 10 cents since the beginning of the year.

The currency remains incredibly strong however, and many analysts are looking ahead to the tropical storm that is heading towards Queensland to see whether any weakness will come from the effects of Cyclone Yasi, with a break above $1.60 being likely.

The dollar hit 12-week lows overnight, heading toward key support versus a basket of currencies as solid manufacturing data this week, low US yields and stimulative US monetary policy pushed towards riskier assets.

Strong manufacturing numbers from America and other countries fuelled optimism on global economic growth, with expectations of loose US monetary policy further encouraging risk-taking as concerns over euro zone peripheral debt seemed to be contained for now.

GBP-USD rates peaked above $1.60 for the first time all year yesterday, and buyers of this pairing will benefit from placing stops in the market to protect against any downside.