Costs for BoE of raising rates before Fed might be prohibitive

By Patrick Graham

LONDON (Reuters) - Although David Miles has hinted the Bank of England could raise interest rates before its U.S. counterparts, market pricing suggests some old truths about the rate of sterling will continue to tie its hands.

Outgoing BoE Monetary Policy Committee member Miles said last month it would be daft to think the Bank had to wait for the Federal Reserve before moving. Earlier this week, money markets were close to betting outright the BoE might move first.

But other indicators still put the U.S. first. The Chicago Mercantile Exchange's tracker of the probability of a U.S. rise in December, based on money market rates, now stands at 66 percent while similar indicators for the BoE are nearing 40 percent. <0#FSS:>

Strategists say a BoE opening move would drive sterling sharply higher, with potentially disastrous effects for UK companies selling goods and services to the euro zone and China.

"If the BoE went first it would have a huge impact on sterling," said Sam Lynton-Brown, BNP Paribas currency strategist in London. "If the BoE were to go first, we'd be talking about several big figures at least on sterling against the euro."

Two-year interest rate swaps on sterling, another proxy for expectations of BoE rates that has shown a strong correlation with the dollar exchange rate, are up 36 basis points since mid-March and now stand at 1.16 percent, just 15 points off where they were when sterling reached $1.70 last year.

RHETORIC

All this talk has already driven sterling to more than 7-year highs against the euro and a broader basket of currencies.

But whereas Fed policymakers have kept reasonably quiet on the dollar's gains in that time, BoE officials have discussed it publicly at length. Importantly, exports account for around a third of Britain's economy, compared to just over 10 percent in the United States.

In a pair of speeches turning a more hawkish tack in mid-July, Governor Mark Carney said that while sterling's gains did not remove the need for higher rates and was not the dominant factor, it was "particularly relevant" for policy.

"We continually have these self-correcting episodes," says Matt Cobon, Head of Government and FX Investments at Columbia Threadneedle Investments in London, who believes the BoE will take its time with any rise in rates.

"Whenever the Fed or the BoE thinks about tightening conditions, the market does it for them and then they're back to square one," he says. "The euro zone has clearly been a drag for the BoE."

Economists continue to struggle to quantify how much impact on growth sterling rises have but the direction of travel was clear in the breakdown of second quarter growth numbers.

The figures last month showed an increased reliance on domestic demand, with business and financial services powering ahead, while factory output fell in the face of a stronger pound.

Cobon also thought the latest round of falls in commodity prices had a bigger impact on London's stock market. A number of strategists and traders have argued in the past week that sterling looks overbought ahead of a "Super Thursday" of BoE publications this week.

"If the BoE were to be going first, it would mean that sterling would overshoot," said Hans Redeker, head of global FX strategy with Morgan Stanley in London.

"The BoE knows that. It knows that sterling is of vital importance to the economy and it knows that a small place like the UK cannot afford to go first."

(Writing by Patrick Graham; Editing by Tom Heneghan)