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Fed and BoE dismantle sterling rate support :Mike Dolan

FILE PHOTO: Federal Reserve Chair Powell announces interest rate hike during news conference in Washington

By Mike Dolan

LONDON (Reuters) -The U.S. Federal Reserve and the Bank of England sent two very clear signals to financial markets this week - don't underestimate how high U.S. interest rates will go and don't overstate peak UK rates.

By design or not, the deliberately crafted messages opened another trapdoor under sterling by widening the Transatlantic gap between Fed and BoE 'terminal rates' for 2023, a spread which crossed again this week in the dollar's favour for the first time since the British fiscal shock began brewing in August.

The pound duly took its cue and dropped almost 2% against the U.S. currency following the one-two salvo - its worst one-day hit since the botched British budget of Sept. 23.

The jawboning on both sides of the ocean was a curious attempt to fine tune market expectations rather than some random asides at respective press briefings.

As both central banks delivered swingeing 75 basis point hikes to their main policy rates this week, the Fed on Wednesday pushed back against any vain investor hopes that the end of its tightening cycle may be nigh - even if the sheer pace of hiking inevitably slows from here.

The net effect was to catapult next year's implied Fed terminal rate well above 5%. Both one and two year rates soared to their highest in 15 years and show that little to no retreat from those peaks seems likely over that horizon.

And with the dollar re-invigorated worldwide as a result, the BoE supercharged it against the pound on Thursday by insisting money markets had got it wrong about either its willingness or ability to match those U.S. peak rates above 5%.

"Based on where we stand today, we think Bank Rate will have to go up by less than currently priced in financial markets," said Governor Andrew Bailey in an unusually blunt message delivered even as implied market rates had retreated by half to 4.75%.

The BoE's argument was pretty simple. Britain's economy simply can't take that level of monetary tightening and if it matched prior market assumptions of peak rates at 5%-plus then Britain would sink into its worst recession on record lasting two full years.

That view is reinforced by fears the British government's fiscal plan will now swing back from the wildly destabilising tax cuts of September to a biting austerity of spending reductions and tax rises later this month.

What's more, the peculiar exposure of Britain's high percentage of homeowners to brutal mortgage rate rises only rams home the limitations of a scorched earth interest rate policy.

Independent British think tank the National Institute of Economic and Social Research estimated on Thursday that monthly variable rate mortgage repayments by some two and half million households would double if BoE rates hit 5% - and 30,000 households could have monthly mortgage payments exceed their incomes.

To be fair to the Bank, it has been flagging disagreement with market pricing for a couple of weeks. BoE deputy chief Ben Broadbent already insisted these was excessive on Oct. 20.

But given markets' implied terminal rate had declined by some 50bps to 4.75% since then, investors wonder what the need to restate it now means and are increasingly unsure of just how what level of rates the BoE is now willing to entertain.

BANK "IN A HOLE"

Although the BoE insisted further hikes from 3% would likely be needed, two of the nine person policymaking council voted for a smaller rate rise this week. And the Bank's own models suggest it could basically hit its 2% inflation target in two years' time anyway if rates stayed here at 3%.

"The implications are that the BoE has done the majority of what they feel they need to do and we may not even see a 4% handle on the base rate," said Candriam fund manager Jamie Niven. "Given underlying economic challenges for the UK and the lag in the impact of recent hikes, I tend to agree. The stark contrast to the tone of the Fed last night is notable."

State Street's EMEA macro strategist Tim Graf also thinks a terminal rate closer to 4% is now "the more likely end state for policy rates."

All of which spells more trouble for an ailing pound - just 7% off a record low of $1.0380 hit during September's shock. If British inflation doesn't dissipate quite as quickly as Bank models assume and the BoE remains as doubtful about the horizon for peak rates as it did this week, then relative real yields could sap sterling even further.

A in a vicious circle could then whipe up. The BoE needs to be super careful about the pound because another withering lurch will simply aggravate import and energy price inflation.

"The Bank is stuck in a hole," said GAM Investment Director Charles Hepworth. "It's difficult to see how this currency doom loop can be escaped."

Edward Park, Chief Investment Officer at Brooks Macdonald, thinks the sterling vulnerability makes the BoE task near impossible and would leave investors nervy about still shaky British bond markets. "Bond markets will bear in mind that the UK is not fully in control of its inflation destiny."

The opinions expressed here are those of the author, a columnist for Reuters.

(by Mike Dolan, Twitter: @reutersMikeD; Editing by Josie Kao)