The Bank of England’s larger-than-expected rise in interest rates provided only a fleeting boost to sterling on Thursday as investors bet that the aggressive action from the central bank is likely to help push the UK into a recession later this year. 

Sterling briefly jumped following the BoE decision to lift borrowing costs to 5 per cent from 4.5 per cent previously. But the gains faded fast, with the currency trading 0.1 per cent lower against the dollar at $1.2758, below the level seen before the rate announcement.

Two-year UK government bond yields, which are sensitive to short-term interest rates, fell slightly to 5.03 per cent from 5.06 per cent.

Although the moves were relatively small, investors said markets were focusing on the growth-sapping effect of rate rises, upending the typical correlation between higher borrowing costs and a stronger currency. Further sterling weakness, which drives up the cost of imported goods, could be a headache for the BoE in its struggle to curb inflation.

“The market is implying that this hike will kill growth, and reduce inflation, and I think the market is right,” said Mike Riddell, a bond portfolio manager at Allianz Global Investors.

The rate rise comes after the latest evidence of stubbornly high price rises. UK inflation remained stuck at 8.7 per cent in May, according to data published on Wednesday, higher than the 8.4 per cent expected.

Core inflation, which strips out volatile food and energy prices, rose again in May to 7.1 per cent from 6.8 per cent the previous month, the highest rate since March 1992. 

That data had driven the pound lower earlier this week, ending a three-week period of gains against the dollar, despite traders betting that BoE rates will climb as high as 6 per cent by the end of the year.

“The idea that we can just take the heat out of the labour market without a recession has not happened historically in the UK,” said Tomasz Wieladek, chief European economist at T Rowe Price. 

“Everyone has really underestimated the inflation impact coming to the UK economy — it’s possible that the BoE hikes to 6 per cent but sterling still depreciates,” he added.

Ahead of Thursday’s decision, the BoE had been expected to increase rates by 0.25 percentage points, but markets had been pricing in a 45 per cent chance it would move to 5 per cent ahead of the meeting. 

Jordan Rochester a foreign exchange strategist at Nomura, said the rate increase “could lower the odds of more hikes needed later this year”, weakening sterling.

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