The pound fell to a two-week low as comments from the Bank of England governor led to markets rushing to anticipate more interest rate cuts in the months ahead.
Andrew Bailey said the central bank could become a "bit more aggressive" in cutting rates if inflation remains in check.
Versus the dollar, sterling dropped to $1.313, down 1.1% today and over 2% over the past five days from its recent two-and-a-half-year highs, with economic data on Thursday also potentially further fuelling the decline. Against the euro, the GBP fell 1% to £0.8409.
Bailey, who next convenes with the BoE's monetary policy committee in early November, gave the comments in a Guardian interview, where he said the committee could become "a bit more activist" on rate cuts if inflation continued to ease.
Inflation watch
This week, with oil prices rising again amid fighting in the Middle East, there have been concerns raised about inflation being pushed back up after retreating during the past year. The consumer prices index most recently fell to 2.2% – just above the BoE's official 2% target.
Asked about the fighting between Israel and Iran, he said "geopolitical concerns are very serious" and there "are obviously stresses and the real issue then is how they might interact with some still quite stretched markets in places".
Bailey said the Bank watches development closely to see the impact of the latest news, but conversations with counterparts in the region suggest "a strong commitment to keep the market stable".
The Iran-Israel fighting had already been dragging on the pound and some other currencies as investors sought the relative safe haven of the US dollar.
Sterling work
Bailey's more "dovish" comments rattled sterling further, said market analyst Katheleen Brooks at XTB, though the GBP is still the best performing currency among G10 currencies so far this year.
"Bailey’s comments have also undermined the pound’s yield differential with the US and Europe," she said, noting that the market has now fully priced in a rate cut from the BoE next month, and a 61% chance of another cut in December, up from 47%.
This means the market is now expecting six rates from the BoE by the end of next year, up from just over five rate cuts earlier this week.
"The market has used Bailey’s comments as a green light to price in more monetary loosening," said Brooks.
"GBP/USD has already sold off sharply this week, so further downside could be limited in the short term, however, Bailey has made it harder for the pound to recover. For that to happen, we may need to see both upside surprises to UK price data and an easing of tensions in the Middle East."
Pressures on the pound
While Bailey’s comments provided the trigger for the sell-off in the pound this morning, Jane Foley, senior currency strategist at Rabobank, said the aggressiveness of the move likely took its cue from a couple of additional factors, including the recent "go big or go home" attitude towards monetary stimulus, see at the US Fed, the Chinese authorities and Riksbank, with expectations of a more aggressive move for the RBNZ next week and that the ECB may now cut rates twice this year rather than once.
"Since overseas rate cuts can have an FX impact, technically there could be an incentive for the BoE to follow suit," said Foley.
Inflation risks in the UK are still a source of concern, as seen in Bailey's caveats to his comments.
Headline inflation is projected to rise from 2.2% to around 2.6% on average in the fourth quarter, but as this is driven largely by energy and base effects, Foley and her colleagues think this is unlikely to prevent a BoE cut in November, but could be enough to keep a December rate cut off the table.
"This backdrop suggests that this morning’s GBP sell-off may be overdone," Foley said.
Rob Wood, chief UK economist at Pantheon Macroeconomics, said the services PMI and BoE's decision maker panel (DMP) surveys on Thursday complicated the picture further.
The Bank will "take comfort" from easing output price inflation shown in the PMIs but "will be wary of rising input costs feeding through at a later date", with the survey containing various factors that support the MPC "taking a gradual approach" to reducing rates.
While Bailey's comments indicate a growing change that there could be back-to-back cuts in the November and December meetings, he said the DMP survey suggests otherwise, with with wage growth and price rises proving stubborn.
** Update: adds new details, comments **