Pound slides on BoE rate cut as investors fret about 'stagflation'

By Harry Robertson, Naomi Rovnick and Greta Rosen Fondahn

(Reuters) -Investors grappled with a gloomy set of Bank of England forecasts on Thursday that complicate the outlook for UK assets, with sterling set for its biggest one-day fall in four weeks even as bond yields held broadly steady.

The BoE lowered rates to 4.5% and halved its growth forecast for this year to 0.75%. But it said inflation would rise "quite sharply" to peak at 3.7% this year, well above a previous estimate.

"With growth under threat and inflation remaining higher than hoped, that provides a combination that is likely to see the word 'stagflation' being bandied around," said Premier Miton Investors CIO Neil Birrell.

BoE Governor Andrew Bailey rejected the idea that Britain was experiencing a period of "stagflation", a term coined to describe a combination of high inflation and weak economic growth, saying underlying inflation remained on a downward path.

Yet the reaction in financial markets hinted at concerns about a more sombre picture.

Sterling was already on the back foot and extended falls to trade about 0.8% lower at $1.241. It was heading for its largest daily fall since January 10 and was down from Wednesday's four-week high.

Investors added to rate-cut bets and expect roughly 66 bps of further easing this year, from around 60 bps before the decision.

That backdrop could support a bond market that took a beating in early January amid a global selloff and concerns about government plans to ramp up borrowing to spend more on public services and investment.

Two-year bond yields, which are sensitive to rate expectations, briefly fell to their lowest since October even as U.S. and European yields held broadly steady.

But 10 and 30-year yields ticked higher as prices slipped, pushing up longer-term government borrowing costs.

MANN ALIVE

Investors homed in on the fact that two members of the rate-setting Monetary Policy Committee (MPC) called for a deeper 50 bps cut, one of whom - Catherine Mann - had previously voted to hold rates steady.

Britain's economy has barely grown since mid-2024. Business and consumer sentiment fell after Labour's October budget while the risk of a global trade war has risen.

"The weaker than expected data coming out of the UK since the last BoE meeting has clearly encouraged them (policymakers) to be more aggressive," said Paul Jackson, global head of asset allocation research at Invesco.

Nick Rees, head of macro research at Monex Europe, said currency markets had over-interpreted Mann's vote.

"The move in gilts or the lack of it is probably the right read, FX markets have over-interpreted it in a bit of a knee jerk reaction that I would expect to reverse," he added.

The BoE's meeting minutes said one policymaker described as supporting an "activist" approach still expected monetary policy would need to stay restrictive for some time.

London's FTSE 100 rose to a record high and was last up 1.5%, also boosted by strong earnings reports. The FTSE tends to rise when the pound falls as many of its constituents are exporters.

British homebuilding stocks, which benefit from lower rates, rose to their highest level in over 12 weeks.

Invesco's Jackson said he remained positive on UK equities and government bonds after the decision.

TRADE SECRETS

Speaking days after U.S. President Donald Trump threatened Mexico and Canada with 25% tariffs, the BoE said higher global trade levies were likely to cause slower growth, although it could not officially incorporate them into forecasts.

Luke Bartholomew, deputy chief economist at fund manager abrdn, said worries about tariffs may have informed Mann's decision to call for deeper rate cuts.

"They can't formally forecast the trade war effects but the spectre is hanging over the growth forecasts as well," he said.

"The decision is driven by more than just the changes to the baseline forecast."

Global trade tensions have so far done little to dent UK stocks, but sterling has swung along with other currencies as investors try to gauge the risks to trade.

The move lower in UK borrowing costs - the third reduction since August, when rates stood at 5.25% - contrasts with the United States where the Federal Reserve is keeping borrowing costs on hold.

The European Central Bank is cutting rates, however, as euro zone growth falters.

(Reporting by Harry Robertson and Naomi Rovnick in London, and Greta Rosen Fondahn in Gdansk; Additional reporting by Samuel Indyk in London; Editing by Amanda Cooper, Dhara Ranasinghe and Catherine Evans)