The UK CPI data for June is out tomorrow and headline annual inflation is estimated to drop from 8.7% in May to 8.2% in the last month. However, core annual inflation is estimated to hold steady at 7.1%. The latter is still the main focus as food price inflation especially continues to run hot in the UK. And just keep in mind that in each of the last four readings, core annual inflation has beaten estimates and expectations:
Will it do so again this week? If so, how will that impact the pound? Let’s try to wrap our heads around this matter.
As things stand, markets are already sensing that the BOE needs to step up their game and tighten policy further to prevent inflation from getting out of control. The odds of a 50 bps rate hike for August now stands at roughly 66% with a terminal rate of roughly 6.06% priced in as of today.
On the latter, that is a modest repricing from the near 6.50% earlier this month. However, one can certainly argue that there was an overshoot in terms of hawkish expectations at the time. It is only July but markets were seeing the BOE peak rate to come in during March next year – which implies a considerable amount of rate hikes in the next five to six meetings.
I mean let’s be real. This is a time when markets can’t even look to two or three meetings ahead. So, to try and make bets over what is to come in the next eight to nine months is a bit of a stretch. As such, those convictions may not be too strong as they will have to be reassessed according to the data and the upcoming central bank decisions.
It’s easy to speak in hindsight but the best thing we can do as traders is to take lessons from the past. And in this instance, we don’t have to look too far away to see how markets have repriced Fed odds after the banking crisis in March to April have settled down.
Going back to the BOE and the pound, another hot set of inflation numbers this week is going to keep the fire alive on more hawkish expectations. But after having seen what I would say is „peak hawkishness“ in pricing in a 6.50% bank rate, it’s hard to imagine any further significant hawkish turns for the pound from hereon.
In other words, the pound may still get a lift on a beat in the inflation report but perhaps not as strong as before.
Instead, I would think towards the opposite. At some point, these hotter-than-expected inflation numbers in the UK are eventually going to weigh further on the economy amid the cost-of-living crisis. And when you add that to tighter financial conditions and higher interest rates choking out credit demand, there is a real risk of stagflation in the economy.
And I would argue that we are getting closer to that ‚breaking point‘ where the pound may look to the high inflation numbers and say: „Hey, this is getting out of hand and the economy is shot. High interest rates are not addressing the problem and these tighter financial conditions may end up breaking something or at least induce a hard landing.“
If that is the case, I would imagine that higher inflation readings will start to reflect badly on the pound. We’re not quite there yet I would say but if there are cracks starting to show up in the labour market especially, there might be scope for a sharp correction in sterling down the road.
This article was written by Justin Low at www.forexlive.com.