GBP/USD: Trading the UK Consumer Price Index

Price growth in the U.K. is expected to fall further as economists forecast the consumer price index to fall to an annual rate of 2.6% from 3.0% in January, and as the outlook for growth and inflation falter, fundamental headwinds are likely to weigh on the British pound as market participants anticipate the region to face its worst recession since World War II.

[B][U]Trading the News: U.K. Consumer Price Index[/U][/B]

[B][U]What’s Expected[/U][/B]
Time of release: [B]03/24/2009 09:30 GMT, 05:30 EST
[/B]Primary Pair Impact : [B]GBPUSD[/B]
Expected: 2.6%
Previous: 3.0%

[B][U]Effects the U.K. Consumer Price Index had over GBPUSD for the past 2 months[/U][/B]

[U]January 2009 U.K. Consumer Price Index[/U]
The U.K. consumer price index fell another 0.7% in January, which lowered the annual rate to a nine-month low of 3.0% from 3.1% in December, and the outlook for price growth remains bleak as the economy heads into a deepening recession. The breakdown of the report showed clothing and footwear led the decline as prices slipped 4.7% from December, while prices for alcohol and tobacco increased 1.9% during the month. The data continues to reinforce a dour outlook for growth and inflation as economic activity deteriorates at a rapid pace, and price pressures are likely to fall further as global commodity prices remain weak. As a result, BoE Governor Mervyn King said that the central bank may have to increase the money supply in order to keep prices from falling too far below the 2% target for inflation, and forecasts price growth to reach an annual rate of 0.5% by the end of 2010.

[U]December 2008 U.K. Consumer Price Index[/U]
Consumer prices in the U.K. fell 0.4% in December to an annual rate of 3.1% from 4.1% to mark its biggest decline since 1997. A deeper look into the report showed that clothing and footwear led the decline as prices slipped 4.2% during the month as retailers slashed prices to lure potential shoppers, which lowered the core rate of inflation to a two-year low of 1.1% from 2.0% in November. As price pressures weaken at a rapid pace, the Bank of England is widely expected to lower the benchmark interest rate further in an effort to stimulate the ailing economy as the central bank maintain its dual mandate to ensure price stability while fostering economic growth, and may adopt a zero interest rate policy over the near-term as Europe’s second largest economy is expected to face its worst economic downturn since World War II.

[B]What To Look For Before The Release[/B]
Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

                        [B][U]Bullish Scenario:[/U][/B]
         
         If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on GBPUSD ahead of the data release.

[B][U]Bearish Scenario:[/U][/B]

         If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on GBPUSD ahead of the data release.


[B]How To Trade This Event Risk[/B]

Price growth in the U.K. is expected to fall further as economists forecast the consumer price index to fall to an annual rate of 2.6% from 3.0% in January, and as the outlook for growth and inflation falter, fundamental headwinds are likely to weigh on the British pound as market participants anticipate the region to face its worst recession since World War II. The preliminary GDP report for Great Britain showed that the annual rate of growth contracted 1.9% in the fourth quarter, which was the biggest drop since 1980, and as economic activity deteriorates at a record pace, price pressures are likely to weaken further as firms continue to lower the costs of goods in an effort to spur domestic demands. The producer price index fell to an annual rate of 3.1% from 3.5% in January, while the core rate of inflation slipped to 3.7% from a revised reading of 4.0% in the previous month, and the data foreshadows a deepening downturn in the economy as the Bank of England forecasts the annual rate of growth to contract 4.0% in the first quarter and projects price growth to reach 0.5% by the end of 2010. As the central bank hold a dour outlook for growth and inflation, policy makers are likely to employ all of their available tools to stimulate the ailing economy as the board maintains their dual mandate to ensure price stability while fostering economic activity. At the same time, we may see the BoE expand its policy for quantitative easing as the benchmark interest rate holds at a record low, and may extend its purchase to a broad array of assets in the months ahead as the MPC attempts to stem the risks for deflation. BoE Governor Mervyn King said that the unprecedented step taken on by the central bank was crucial ‘to keep inflation at target in the medium-term,’ and went onto say that the inflation outlook ‘provides a natural guide’ for monetary policy. Nevertheless, as the board sets up a three-month timeframe to carry out the new policy objectives, deteriorating fundamentals are likely to weigh on the exchange rate as economic activity weakens at a record pace however, a rise in risk appetite would certainly help to bolster the appeal of the British pound as investors turn bullish against higher-yielding assets.

Expectations for weaker prices certainly favors a bearish forecast for the British pound however, as global commodity prices creep higher with the Bank of England expanding the money supply, an enhanced CPI would set the stage for a long pound-dollar trade following the release. Therefore, if the CPI holds steady at an annual rate of 3.0% or falls to 2.9%, we will look for a green, five-minute candle subsequent to the event to confirm a buy entry on two lots of GBPUSD. Once these conditions are met, we will place our initial stop at the nearby swing low (or reasonable distance taking volatility into account) and this risk will determine our first target. Our second target will be based on discretion, and in an effort to preserve our profits, we will move the stop on the second lot to breakeven once the first trade reaches its target.

On the other hand, fears of a deepening recession paired with increased turmoil in the global financial market is likely to weigh on economy, and as growth prospects deteriorates at a rapid pace, price pressures are likely to fall further as demands from home and abroad falter. As a result, an in-line print or a CPI reading below 2.6% would lead us to sell the British pound, and we will follow the same setup for a short pound-dollar trade as the long position listed above, just in reverse.
[B]Price Growth Improves - Stronger Than Expectations[/B]

[B]Increased Risks for Deflation – Lower Than Expectations
[/B]