By Amanda Cooper
LONDON(Reuters) - Sterling fell on Monday, but was still headed for its largest monthly gain in over a year after the turbulence in British politics over the last few weeks finally appeared to subside.
The pound, which hit a record low of $1.0327 against the dollar in late September, has risen by 3.5% in October, the biggest one-month gain since July 2020, when it rose by 5.5%.
Since September's all-time low, it's regained 11% in value.
The Bank of England is likely to raise interest rates by another 75 basis points when it meets later this week. The British economy is slowing, but soaring energy costs and a week currency have fuelled a cost-of-living crisis that has pushed consumer inflation into double digits.
With that in mind, analysts said the markets may be overestimating what the BoE might do and the scope for a dovish surprise was larger than is currently priced in.
"The market firmly prices 75 bp, but we think the risk of a softer 50 bp is under-priced as the BoE prepares for the coming recession," ING strategist Chris Turner said.
"As we have argued previously - now that a lot of the fiscal risk premium has come out of sterling - the forthcoming tighter fiscal and more dovish than expected monetary policy could prove a bearish combination for sterling," he said.
Former Prime Minister Liz Truss's economic plan, which contained billions in unfunded tax cuts, sent the gilt market into a tailspin, forcing a dash among pension funds and other asset managers to raise extra cash for collateral as the value of their bond holdings plummeted.
Since then, Truss has been replaced by former finance minister Rishi Sunak, who has retained Jeremy Hunt as chancellor. Hunt has ditched almost all the proposals in Truss's plan, returning a semblance of stability to UK markets and toning down a lot of the hawkishness around rate expectations.
The pound was last down 0.6% against the dollar at $1.1545 and down 0.3% against the euro at 86.05 pence.
Money markets show traders are attaching a near-100% chance of a three-quarter point rate increase from the BoE. UK interest rates are currently expected to peak at around 4.87% in September next year, up from 2.25% right now.
"A stitch in time saves nine and it would be better to increase rates by 0.75% to show commitment to inflation-fighting as well as fiscal prudence," Newton portfolio manager Howard Cunningham said.
"If the MPC is seen to be dovish, with the autumn statement delayed to 17th November, there is a danger investors might lose patience which could cause renewed volatility, though unlikely on the same scale as recently."
In the aftermath of Truss's so-called mini-budget, UK money markets showed traders expected rates to peak above 6% next September.
(Reporting by Amanda Cooper; Editing by Nick Macfie)