GBP/EUR Forecast to Rebound Eventually - Sterling Faces Inflation, Productivity Data Over Next 48 Hours

The UK's rapid pace of economic expansion, while the best in the developed world, appears to be slowing. As a result the pound sterling exchange rate complex has experienced weakness.

(IUpdate: UK inflation has fallen faster than expected - year-on-year inflation fell to 1.2% in September, well below expectations of a decline to 1.4%. GBP being sold off).

The UK's economic profile is slowing and the Bank of England will be watching closely. The Bank's Monetary Policy Committee errs on the side of caution and hence markets are pushing back their expectations for an interest rate rise.

The pound exchange rates have fallen in tandem. "Sentiment towards GBP remains relatively soft, with expectations for the first UK rate hike continuing to be pushed back. The OIS curve suggests this is now priced in for around July 2015. We still see scope for GBP gains should UK rate expectations get brought forward," say Lloyds Bank Research.

For today, UK CPI will be a focus; the market is expecting inflationary pressures to have slipped slightly to 1.4% y/y in September.

"However, with decent labour market data expected tomorrow, and wage growth expected to pick up, any dip in GBP on the CPI data could be seen as a good buying opportunity for GBP," say Lloyds.

Sterling looks like this on Tuesday:

The British pound to euro exchange rate (GBP/EUR) is 0.17 pct lower than last week's close at 1.2594.
The British pound to US dollar exchange rate (EUR/USD) is 0.65 pct lower at 1.5981.
The pound to Australian dollar exchange rate (GBP/AUD) is 0.38 pct lower at 1.8268.

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Inflation Falling: Good News for Consumers, Bad News for Sterling-Bulls

Oil prices and energy prices are tumbling. As an example look at the fall in brent crude prices which have plummeted from highs of 114 USD a barrel down to 89 USD.

This has sparked a price war at the petrol pumps - presenting consumers and businesses with a welcome fall in prices.

"With the energy price outlook having deteriorated of late, the near-term inflation outlook seems set to provide an easier backdrop for the BoE to leave interest rates on hold," says Bank of America Merrill Lynch analyst Nick Bate.

The reason GBP is under-performing this October is because the possibility of rates being left on hold for longer has risen.

Where markets had expected a rate as early as end of year 2014 at the earliest we could now only witness rate rises in Summer 2015.

The pound will have to re-rate lower.

"We now expect CPI inflation to remain at around 1.5% over the next few months: some way below the BoE’s central August Inflation Report projection of around 1.9%" says Bate.

BUT - Will the BoE Be Easily Swayed

However, as always, anticipating the Bank of England's moves will be tricky.

Bate points out that while inflation may be falling, the longer-term outlook suggests it will remain stubborn.

One thing that could be masking the real underlying inflation trend is the stronger British pound.

The stronger sterling means import costs are lower, which in turn keeps inflation lower.

BoE member Kristin Forbes recently highlighted that the circa 10% appreciation of sterling since spring 2013 could be pulling down on
CPI inflation by around 0.8pps at present.

Bates points out, therefore, that core inflation excluding import price effects could actually be above the BoE's target at around 2.5% or so.

"Clearly, such strength could clearly be of concern to the BoE," says Bate.

If this is the case then markets will be wary to push the pound too far.

WATCH for the latest inflation statistics due on Tuesday the 14th of October.

Keep an Eye on UK Wages This Week

Bate points out that the ultimate economic influencer of the BoE remains the labour market:

"Stronger signs of wages picking up more swiftly than productivity remains the factor most likely to lead to a rate rise, in our view. The recent upward revisions to productivity (though only moderate) over the last few years may also give the BoE more confidence in its expectations of further strengthening."

Are wage packets rising above inflation i.e are people getting richer?

On Wednesday the 15th of October Average Earnings data is realesed and we could get an answer. Markets will be keeping a sharp eye on whether last month's increase of 0.7 pct is beaten.

If it is expect the pound to rally.

Either way, Bank of America Merrill Lynch are, alongside the markets, looking to push back their expectations of an interest rate rise:

"After increasing in spring and summer, some of the pressure for an imminent rise in interest rates has eased. The risks of a later rise in interest rates than our current expectation of February 2015 are rising."

Lloyds Bank Research echoe this view when they tell us:

"The first UK rate hike now pushed out to July – after the first move in the US. While 2 year yield spreads have moved slightly in GBP’s favour, this has been a result of lower US rate expectations further out rather than any move in UK rates."

Surely a Rally is Possible?

However, Lloyds caution that it seems expectations are now at risk of being brought forward again.

If this is the case then the GBP could well be poised to edge forward alongside these rate expectations.

We also note the pound to dollar exchange rate is oversold on a technical basis - surely a rebound is due?

And what about the pound to euro exchange rate? GBP/EUR is predicted to re-find it's upside traction particularly as the European Central Bank looks to pump extra cash into the Eurozone economy taking its balance sheet back to 2012 levels.