By Mike Dolan

LONDON (Reuters) – Although markets have become increasingly aggressive in pricing a UK interest rate rise as soon as next May – several months at least before the United States or euro zone – sterling seems reluctant to follow.

Next week, Bank of England policymakers will meet and they seem to be evenly divided on the issue of whether basic conditions are necessary for raising the main interest rate of the central bank from the historic low of 0.1%.

In August 2018, Britain’s annual inflation rate rose more than 1 percentage point higher than the BoE’s target of 2%. This was due to pandemic base effects, supply disruptions and other factors such as Brexit disruptions. In the UK, labor markets have been tightening much more than predicted as companies open up and state subsidies are cut. Meanwhile, domestic energy prices have skyrocketed.

This has led to forecasters from major international banks like JPMorgan (NYSE;) and Goldman Sachs (NYSE.:) now expecting UK interest rates rise in May – six months earlier than the consensus predictions of Reuters polls and six months before the U.S. Federal Reserve pulls the trigger.

Two-year gilt yields have risen to 0.28%, their highest point since March 2015 when the pandemic erupted. The 2-year yield differential between U.S. Treasuries and gilts has moved into positive territory, for the first-time since before 2016’s Brexit shock.

However, the pound is still one of the best performing currencies in recent years. This was despite the fact that it has been struggling to recover from the COVID-19-induced shock.

With the uncertainty of the economy and the inflation outlook, perhaps few people in the currency market think that Bank of England would go so far as to outdo the Fed and the other G4 central bankers by at least six months. If the Bank were to see the pound rise in anticipation of this, it could be a sign that the Bank is putting too much pressure on financial markets at the wrong time.

Even though the Fed adopted an average inflation goal for the future, it may not be as rigid as they had intended. The BoE is now tied to a flat inflation target of 2.2%.

There are many other factors that can rein in sterling.

TERMINAL RATES

HSBC’s Dominic Bunning reckons sterling’s outperformance earlier in the year largely priced the chance the BoE would be an early mover on rates and points out that speculative market positioning has already turned on the pound.

However, Bunning believes the more long-term effects of being forced to move early on rates were to reduce the rate of interest over the course of time or the BoE’s “terminal rate”. HSBC will continue to stick with the $1.34 yearend outlook – which is 3% less than it currently has.

He said that “any hiking cycle in UK is likely to have an incredibly slow and limited pace in terms of the final rate” and cited the UK’s flat yield curve as evidence. Also, a number of Bank of England policymakers commented on the fact that the UK’s neutral interest rates are lower than they were before.

Even though the UK has a gap in its 2-10 year yield curve of 50 basis points, it is only 30 bp less than May’s peaks. It remains at least half pre-Brexit voting levels.

The pound could be facing a double-edged sword as concerns about inflationary pressures in the UK due to rising retail energy prices are more immediate.

Deutsche Bank (DE:) strategist Shreyas Gopal reckons the jump in energy prices has been a key factor in repricing in the rates market as it points to UK retail prices jumping from next April just as other inflation base effects are ebbing.

He believes that an earlier rise in rates would not only affect trend growth, but also have a negative effect on the UK’s current and trade terms.

Deutsche projects that the UK’s current account deficit could increase from its existing 3% to 0.25 percent by extrapolating the rising demand and the sharp fall in energy production this year into the fourth quarter.

It is not common for the BoE before the Fed to enter an interest rate tightening period. In 2003, it raised policy rates six months earlier than the U.S. did.

However, much structurally has changed for Britain in the past six months, with the Brexit vote and the bank crash of 2008. One, since 2016, the UK’s policy rate has been consistently lower than the U.S. counterpart. It had spent the past 30 years, except for very short periods above it.

While the Bank could feel pressured to act early next year, if it remains bound by its inflation target, but the pound does not seem to be impressed with the fact that there’s more fuel in the tank.

(by Mike Dolan. Tweet (NYSE):: @reutersMikeD