Sterling, UK Bonds To Reconnect With British Data After BoE Guidance

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Recent forecast-busting UK economic numbers have had a muted impact on the currency and bond markets, but that is likely to change now the Bank of England has tied its "forward guidance" on interest rates to unemployment.

* BoE's guidance plan to bring back focus on UK data

* Economic numbers to hold sway over pound and gilts

* Volatility to rise before and around UK jobs data

Recent forecast-busting UK economic numbers have had a muted impact on the currency and bond markets, but that is likely to change now the Bank of England has tied its "forward guidance" on interest rates to unemployment.

After improving data such as July's jump in services sector activity and a steady rise in house prices, further improvements, which many anticipate, could see sterling rise and bonds fall, as markets price in rate hikes sooner than previously. That in turn could weigh on UK stocks, analysts say.

The major driver for much of this year has been expectations that the BoE under new governor Mark Carney would issue unprecedented guidance that interest rates would stay low.

That goes a long way to explaining why the pound is 4 percent lower against the dollar at $1.5525 and down 5.6 percent against the euro. Low interest rates make a currency less attractive and keep bond yields anchored.

On Wednesday, Carney said rates would stay at record low levels of 0.5 percent until the jobless rate fell to 7 percent from the current 7.8 percent - a process he said could take three years.

"It was quite liberating that the subject of forward guidance has now been dealt with," said Lutz Karpowitz, currency strategist at Commerzbank. "Sterling is now likely to benefit from positive macro data in the future."

Much to the disappointment of many in the bond market and those positioned for a weaker pound, Carney did not pledge to keep rates low for a specific period. Instead he surprised markets by introducing what analysts called "knockout clauses".

He said the BoE would consider raising rates if its forecasts showed inflation at 2.5 percent or more in 18-24 months, if low rates threatened financial stability, or if medium-term inflation expectations rose significantly.

This will put the focus squarely on economic data.

TESTING THE THEORY

A raft of UK indicators, from consumer prices and retail sales for July to the monthly jobs report, will test this theory in the coming week.

UK unemployment for June is forecast to remain steady at 7.8 percent. But with the economy recovering, some say the jobless rate could drop to 7 percent sooner than Carney suggested.

"Unemployment may be well clear of the current threshold, but as it gets closer to that level, the risk of higher rates at some point will increase," said Adam Cole, head of currency strategy at RBC Capital Markets.

"We expect a partial re-coupling to drive sterling higher against the euro in the remainder of 2013."

That re-coupling with data will hold true for bonds too.

"The bond market is back to the fundamental game of data watching, something that has been sorely lacking throughout this extended period of quantitative easing, central bank watching and euro crisis," Standard Life said in a note.

Rate markets are pricing in the probability of the first 25 basis-point increase in Bank rate in late 2015, a year before the late-2016 date suggested by Carney's guidance.

They are also pricing in approximately 75 bps and 50 bps of hikes in 2016 and 2017, respectively, according to BNP Paribas strategist Shahid Ladha.

Bond investors will be concerned about inflation, given it is already running above target, at 2.9 percent, and unlikely to fall sharply if the economy picks up further. That would give Carney little option but to tighten policy.

"Given the broad-based momentum in the economy, the next move in UK policy seems at least as likely to be a tightening than a loosening, even if it does not take place for some time," Ladha added.

The renewed focus on data will also see volatility rise in the British pound, with steady demand for short-dated options that allow investors to hedge against sharp swings around important economic indicators, as happens with the U.S. monthly payrolls reports.

"Volatility over that specific event, the jobless rate, will be higher," said Saeed Amen, currency strategist at Nomura. "So you are likely to see options more expensive."

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