GBP/USD: Strong UK Inflation Figures Could Spark A Rally Above 2.05

OCT 16
UK CPI (YoY) (SEP) (8:30 GMT,4:30 EST)
UK Core CPI (YoY) (SEP) (8:30 GMT,4:30 EST)

                                   [B]Expected:                          1.9%[/B]
                                   [B]Expected:                          1.8%[/B]
                                                     
                                   [B]Previous:                           1.8%[/B]
                                   [B]Previous:                           1.8%[/B]

How Will The Markets React?
With energy and food costs rocketing over the past two months, inflation pressures in the UK have likely picked up. As a result, headline CPI is estimated to rise an annualized 1.9 percent during September while the core measure of consumer price growth that excludes volatile factors like oil and food are anticipated to have held steady at 1.8 percent. Both of these estimates are below the Bank of England’s 2.0 percent inflation target, but it will take much more than that to persuade the central bank to cut rates before year end. Indeed, the Bank of England has been anticipating a slowdown as Governor Mervyn King said last week, “As we said in August, pressures on capacity mean that output growth needs to slow moderately over the next year or so if we are to continue to meet the inflation target…We will be monitoring closely the impact of tighter credit conditions on demand and output over the coming months. Even though inflation is close to the target and pay pressures are muted, we will continue to look ahead and monitor the risks to inflation that we identified in August: the signs from surveys and financial markets that people expect inflation to pick up; the strength of company pricing intentions, and the recent increases in world commodity prices.” However, there is a risk that the September CPI readings – at least the headline figures – will actually prove to be stronger-than-expected and the data could lead traders to price in the potential for another rate hike this year, especially if CPI jumps above 2.0 percent. On the other hand, surprisingly soft inflation figures could send the British pound rocketing lower and Gilts surging.
Bonds – Long Gilts
Fibonacci support at the 106.01 level has blocked additional Gilt losses, but buyers struggled to sustain the recovery. A potential head and shoulders pattern on the daily charts signal more bearish moves for the contract, with only a push above the 106.72 level able to improve the outlook. Gilts may not have a chance to break higher as UK CPI data may support speculation that the Bank of England will not cut rates this year and that the central bank in fact remains somewhat hawkish. As such, a decline below 106.01 targets 105.34.


FX – GBP/USD
The British pound has done nothing but consolidate gains over the past two weeks against the US dollar, forming a flag formation on the daily charts and signaling the potential for a break higher. The release of UK inflation data on Tuesday could spark the break out, as CPI could prove to be stronger-than-expected give the large increases seen in volatile food and energy costs during the month of September. Traders may be feeling particularly jittery about the outlook for monetary policy by the Bank of England in coming months, especially ahead of the release of the bank’s October meeting on Wednesday. There is speculation that some of the members may have voted for an interest rate cut – which would be highly bearish for Cable – but if CPI highlights that price pressures are mounting in the economy, it will become clear that the Bank of England really has very little room to cut rates. As a result, hot CPI could ignite a GBP/USD rally, with a break of 2.0500 targeting the 26-year highs at 2.0654.


Equities – FTSE 100
The FTSE 100 did an about-face at the 7-year highs near the 6,750 level on Monday, as the index plummeted 1.28 percent by the end of the day. Will stocks on Wall Street taking a beating as well, it is worth wondering if equities are finally taking a turn for the worst for at least the near-term. If UK CPI proves to be much stronger-than-expected, the UK equity index could take yet another hit as the data would reduce the chances that the Bank of England will cut rates before year end. Indeed, BOE Governor Mervyn King is particularly averse when it comes to enacting measures that increase the risk of moral hazard, and if price pressures remain persistent, there is no way he will want to go through with a rate cut. As a result, hot inflation figures could send the FTSE 100 to fall towards Fibonacci support at 6,532. On the other hand, solid performances in other global stock markets along with tepid CPI numbers could allow the FTSE 100 to rebound.

Written by Terri Belkas, Currency Analyst for DailyFX.com