Pound "Reacts more to downside inflation surprises" - RBC Capital

Image © Bank of England

A leading currency strategist says that risk/reward favours being short the British Pound into tomorrow's CPI inflation data release.

Adam Cole, Chief Currency Strategist at RBC Capital Markets, says the data point to little upside potential for the Pound should inflation come in higher than expected.

However, there is significant potential for a sizeable downside move in the event of inflation undershooting expectations, as was the case in the wake of last month's release.

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Cole explains the above chart shows the "surprise" in the monthly CPI releases for the last three years (outcome minus median forecast, horizontal axis) against the change in GBP vs EUR five minutes after the release (vertical axis).

"We also show separate lines of best fit for upside and downside surprises and note that the beta for downside surprises is much bigger (5x bigger) than that for upside surprises. GBP has moved a lot more on downside surprises than upside surprises," says Cole.

The market is looking for a headline CPI inflation print of 6.6%, which RBC Capital's economists also expect.

"GBP has fallen more often than it has risen following upside surprises in the CPI data – even when the surprise has been large (there are more than twice as many observations in the bottom right quadrant than the top right). We think this is a reflection of question marks over the credibility of UK policy that makes the impact of higher inflation more ambiguous for the currency than is the case in other G10 countries," says Cole.

The Pound is, however, under pressure ahead of the midweek release following new data from the ONS that showed UK wages are cooling from a peak, suggesting the Bank of England is likely to maintain interest rates at 5.25% in November.

There is a chance that the move ahead of the inflation release will take the wind out of any post-CPI reaction.