British Pound Outlook: Good Risk-Reward in Buying GBP as Inflation is Set to Bounce Back

- If inflation picks up over coming months, the Pound should follow

- And, a host of economists warn inflation is likely to move higher again

- FX strategists meanwhile see risk-reward in buying Sterling at current levels

Image © cherryandbees, Adobe Stock

We are hearing from a number of foreign exchange strategists that there is a good risk-reward ratio in buying the Pound at current levels amidst expectations for a rebound in the currency following a poor run against a host of competitors.

The Pound has fared particularly poorly against the U.S. Dollar of late having lost 4% in value over the course of the past month alone, against the Euro the Pound has fallen 0.68% over the course of the past trading month.

We reported mid-week that Global FX Capital Pty Ltd believe markets are too pessimistic towards Sterling based on a belief that Theresa May's government is in danger of collapsing because of disagreements on Brexit strategy, and we are now hearing that the economic landscape is also likely to evolve in a manner that should support the currency over coming months.

Of concern to a number of economists is the question of where inflation is headed; Sterling touched five-month lows mid-week after a slowdown in U.K. inflation seemingly kicked deeper into the distance prospects of an interest rate hike at the Bank of England.

UK inflation unexpectedly slowed, coming in at 2.4% annual in April, the lowest rate since March 2017, from 2.5%. Less volatile core inflation cooled to 2.1%, practically hitting the Bank of England’s 2% goal, from 2.3%. While good news for consumers, for currency markets the faster-than-expected cooling in data hints at little need for the Bank of England to deliver that Sterling-supportive interest rate rise that has been mooted for some time now.

The question for those with an interest in the British Pound outlook is whether UK inflation is likely to keep going lower, or recover. If the answer is the latter, then we could well see the grounds for a recovery in Sterling being built.

Economists: This is the Nadir for Inflation

"UK consumer price inflation has fallen back slightly in April, but recent developments suggest this is not necessarily a continuation of a sustained declining trend," says Andrew Sentance, senior economic adviser at PwC who has long been critical of the Bank of England's apparent desire to preside over such low interest rates in the midst of a mature economic expansion.

Sentance warns oil prices are rising sharply and there is speculation it could rise above $100 a barrel over the summer; this should start to make itself felt in prices.

"Sterling remains weak as the Bank of England continues to be reluctant to raise interest rates. Wage increases are also picking up as the UK labour market continues to tighten. Meanwhile, productivity growth remains slow and may recently have gone into reverse," adds Sentance.

The PwC economist says in his view the most likely scenario therefore appears to be that UK inflation will remain stuck around 2.5% over the summer and could pick up in the next couple of months.

Hann-Ju Ho, Senior Economist with Lloyds Bank, says we might just have seen the nadir for inflation, and as a result markets are underestimating the prospect of an interest rate rise by November:

"Our central view is that the Bank will raise interest rates in August to 0.75%. Financial markets are pricing roughly 50% probability to such an outcome and about 90% probability of an increase by November.

"In truth, the Bank of England’s central scenario of three hikes in three years has not changed, but there may be a sense in the markets that rate-setters are erring on the side of caution after the decision not to raise rates earlier this month."

If Ho is correct, market pricing for a Bank of England interest rate will have to adjust, and, based on recent relationships in the exchange rate markets, take Sterling higher.

"Inflation likely will hold steady in May before jumping and exceeding the MPC's forecast in June, encouraging the Committee to raise Bank Rate at its August meeting," says Samuel Tombs, Chief U.K. Economist with Pantheon Macroeconomics.

Tombs was perhaps the only economist who warned that the Bank would opt to leave interest rates unchanged in May at a time when an overwhelming consensus was expecting the Bank to deliver a 0.25% interest rate rise. We feel he therefore has as good a pulse on Bank of England thinking as anyone out there.

Pantheon Macroeconomics believe further declines in food, core goods and electricity price inflation will counter upward pressure on the headline rate from a rebound in transport services and motor fuel inflation in May. "But thereafter, core goods inflation will struggle to fall further in the near term, while electricity prices will rise sharply alongside motor fuel prices."

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Strategists See Value in Sterling

With the prospect of upward surprises on the inflation front likely over coming months, it is perhaps understandable that there are some currency strategists who see value in positioning for a rebound in Sterling around current levels.

A recent note from Credit Suisse shows they believe the Pound is a "buy on dips" prospect given the positive political cycle (from low expectations) ahead of Brexit and muted rate hike pricing.

"Longer-term BoE tightening expectations have been stable despite the dovish BOE tilt at the May meeting," add Credit Suisse, "BoE hawkishness is justified by inflation, unemployment and growth trends even if month-to-month outcomes are volatile."

Importantly, this is a longer-term view and is partly dependent on an assumption that progress is made in Brexit negotiations, we would therefore remind readers that the U.K. currency still has ample scope to extend its bout of weakness in the short-term and picking a good price at which to buy Sterling remains a tricky proposition.

Viraj Patel, a foreign exchange analyst with ING Bank N.V. says in his books there are four developments in his books that would make current levels in Sterling a buying opportunity:

1. UK politics doesn't get messier from here
2. UK activity rebounds in 2Q18 / inflation stays sticky above 2%
3. Global markets weather the current storm
4. BoE hikes in August

At present, it looks to us all the above four points will be met. The only concern we have, and perhaps this is encapsulated in point 1, is the question of Brexit.

Negotiations appear to be tense with increasing hints that little progress will be made by the important milestone of the June European Council summit. If markets start to price in the prospect of a disruptive Brexit that sees the EU and UK default to WHO rules, then Sterling could be in for some sustained selling pressures.

At the time of writing the Pound-to-Dollar exchange rate is quoted at 1.3369, having gone as low as 1.3305 already this month.

The Pound-to-Euro exchange rate is at 1.1421, having gone as low as 1.1270 earlier in the May.

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