By Anirban Nag
LONDON (Reuters) - The Bank of England's move to cool expectations of an early interest rate hike and growing chances it will have to rein in a rampant housing market may only curb sterling's strength, not reverse the trend.
Sterling rose to near a five-year high last week as the UK economic recovery gathered strength. Then it fell to a one-month low against the dollar on Wednesday after the BoE said in its quarterly inflation report it was in no rush to raise the benchmark interest rate from a record-low 0.5 percent.
The central bank saw borrowing costs rising in about a year's time, given the recovery is in its early stages. However, expectations are growing it may try to prevent a housing bubble by tightening standards for mortgage lending.
Britain's housing market has made a swift recovery from the global financial crisis, with prices up about 10 percent in the past 12 months. The gains mean the BoE may need to stop a bubble from forming - without raising rates sooner than it planned.
Speculation is rife that the BoE's Financial Policy Committee will tighten mortgage lending rules when it meets on June 17. That would take some of the pressure off the BoE to raise rates.
But investors are still pricing in a rate increase, based on the strength of the recovery. They look for rates to rise in early 2015, well before the Federal Reserve is expected to tighten and in contrast to the European Central Bank and the Bank of Japan, both of which are loosening policy.
As a result, the pound should remain supported, even though it has gained 9.5 percent against a trade-weighted basket of currencies since Governor Mark Carney took over in July.
"Tightening of macro-prudential norms would only put a break to sterling's rise," said Jeremy Stretch, the head of currency strategy at CIBC World Markets. "There will be no trend reversal. The pound should continue to benefit, especially against the euro and the yen."
Currency investors will draw lessons from New Zealand, where the Reserve Bank in August 2013 tightened mortgage lending norms to cool the housing market. The New Zealand dollar lost 3 percent immediately after those measures, but quickly regained ground, reaching 2 1/2-year highs this year.
The rise in the New Zealand dollar came amid expectations the Reserve Bank would raise rates, despite tightening macro-prudential norms. The RBNZ became the first central bank from the developed world to raise, in March, and followed with another quarter-percentage-point rise in April.
RATE HIKE EXPECTATIONS
New Zealand is not alone. Last year, Norway's banking regulator tightened lending rules, partly to avoid a housing bubble. Expectations of a rate increase declined, and the Norwegian crown lost 12 percent against the euro in 2013. Now Norway is again expected to raise rates, and the crown has climbed to seven-month highs.
"The experience in Norway has shown that macro-prudential norms have the potential to be very important for FX," said David Bloom, the head of currency strategy at HSBC. "It is no longer sufficient to identify pressures on central banks and expect them to respond with interest rate changes."
Should the BoE use macro-prudential norms to control housing prices, Bloom said, the outlook for rates and sterling may change - the central bank might keep rates at record lows for longer.
After Wednesday's inflation report, some investors who were looking to a rate hike as early as late 2014 were forced to reduce bullish positions. The pound was near a one-month low of $1.6743 on Thursday and was toppled from a 16-month high against the euro, trading at 81.60 pence per euro.
The sterling overnight interbank average curve, the very short-term interest rates that form the basis of lending costs to the wider economy, showed investors pricing in a hike in 10 months' time, out from nine months earlier in the week.
But even at 10 months, the BoE is still likely to be the first major central bank to raise rates. So buying the pound at lower levels would be a prudent strategy, analysts said.
"A pound setback will provide renewed buying opportunities, in our view, and we would focus on short euro/sterling strategies," Morgan Stanley analysts said. "Euro/sterling has already pushed lower to new lows for the year, opening the way for a decline towards 79.00 pence."
(Reporting by Anirban Nag; Editing by Larry King)