Pound Sterling's Relief Rally Interrupted by U.S. Inflation Surprise

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A more cheery tone to global markets helped a heavily sold British Pound correct higher midweek, although there remains little conviction amongst analysts that any rebound will sustain itself near-term.

Gains by Sterling were however pared from their highs in early U.S. trade following the release of U.S. inflation data that showed prices continue to rise at a rapid clip, reaffirming expectations for a rapid series of interest rate hikes to come out of the Federal Reserve.

The Pound to Euro exchange rate rose a third of a percent to retake 1.1720 before paring the advance to 1.1698 after global stock markets retreated from earlier highs in response to the data.

The Pound to Dollar exchange rate rose to 1.24 but fell back to 1.2335 as markets digested data showing headline CPI inflation rose 8.3% year-on-year in April, beating the consensus estimate of 8.1%; nevertheless the figure is lower than May's 8.5%.

But it was that beat on expectation that moved markets and saw a prompt spike in the Dollar as investors bet the Federal Reserve will remain vigilant and press ahead with a series of rate hikes.

Core CPI inflation rose 0.6%, doubling the rate of 0.3% recorded in May, but coming in just above the consensus expectation of 0.2%.

Global markets fell in the wake of the inflation data as investors feared yet more interest rates would come out of the Fed in light of the stronger than expected inflation figures.

For Sterling, the below chart tells an important story:

Above: The GBP/USD and S&P 500 (botto) at five minute intervals showing the dip and subsequent recovery in the wake of the U.S. inflation data release. Set your FX rate alert here.

The above shows how closely Sterling is correlated to global risk sentiment; in the above sentiment is embodied in the S&P 500 index (bottom pane) which is widely considered a leading gauge of overall sentiment.

The Pound mirrors action in the S&P 500 and tells us that at present there is a strong correlation between what is happening to the stock markets and the Pound.

Indeed, the same relationship exists for the Pound-Euro rate:

Above: GBP/EUR (top) and S&P 500 (bottom).

Earlier, markets and Sterling rallied with numerous market commentators are today picking up on the retreat in U.S. bond yields, a sign that investors were perhaps starting to consider the implications of a peak in U.S. inflation at around current levels.

It has been the sharp rally in U.S. bond yields that has flagged investor fears over surging inflation while at the same time triggered losses in global stocks.

10‑year U.S. Treasury yields were down to around 2.93% on lower inflation expectations, coinciding with a retreat in the U.S. Dollar which has tended to track Treasuries higher.

But these assumptions were shaken by the data release and yields and the Dollar are better supported at the expense of equities and the Pound.

There are additional factors to consider when looking at Sterling and global sentiment.

Further support for equities today came amidst signs of a potential easing of Chinese covid cases, offering investors hope that the squeeze on the world's second largest economy was nearing an end.

However with no sign that authorities will ease their zero-Covid approach, optimism will remain guarded for now.

"As long as China sticks to its Covid Zero goal, the economy remains vulnerable to a sharper slowdown and risk assets will struggle to sustain a meaningful rally," says analyst Elias Haddad at CBA.

We reported at the start of the week Sterling was ripe for a rebound from oversold conditions and increasingly stretched positioning, rising markets proved to be the catalyst needed to spark a correction higher.

According to the most recently available positioning data Sterling went into the week as being the second-most heavily shorted major currency after the Yen, meaning a sharp counter-trend snap back was increasingly possible.

Furthermore the Pound-Dollar exchange rate entered the new week looking particularly oversold, with the Relative Strength Index on the daily chart reading at 26.36; a RSI reading below 30 indicates a financial asset is oversold.

Often traders take these conditions to signal either a rebound or a stalling in the downtrend is due, as oversold conditions can't persist indefinitely.

GBP Gains to be Temporary say Analysts

Many foreign exchange analysts nevertheless remain of a view corrections higher in Sterling should be viewed as temporary, particularly if global markets continue to lose altitude.

However, should the rebound in stocks extend and prove to be a genuine turnaround, then the Pound could also face brighter prospects.

Near-term recoveries in various GBP exchange rates come after the Bank of England's May policy meeting prompted sizeable falls, leading currency analysts to anticipate further weakness.

Foreign exchange analysts at ING have raised their forecasts for the Euro-Pound exchange rate while also warning that risks to this view are to the upside.

Foreign exchange strategists at investment bank MUFG meanwhile say they hold a tactical recommendation to be 'long' on EUR/GBP, anticipating further gains by the Euro against Sterling.

"We were recently short GBP versus the US dollar and that trade hit our take profit level but we feel we should still be short GBP and this time have chosen the euro as the currency to go long," says Derek Halpenny, Heat of Research for Global Markets EMEA at MUFG in London.

Investment bank Goldmans Sachs have raised their target on a trade betting the Euro will rise further in value against the British Pound.

In a weekly strategy briefing Zach Pandl, Co-Head of Global FX Strategy at Goldman Sachs in New York, says the increased conviction Sterling would fall further against the Euro than initially expected is largely down to the Bank of England.

Goldman Sachs had been 'long' on the Euro-Pound exchange rate heading into the Bank's May policy decision and Monetary Policy Report, but were surprised at just how downbeat Governor Andrew Bailey and his team were on the UK's economic outlook.

The Bank raised near-term inflation forecasts and lowered growth forecasts alongside an announcement they would be raising interest rates 25 basis points to 1.0%.

But long term inflation forecasts were likely to fall below the mandated 2.0% target even without further interest rate rises.

For Goldman Sachs the message and projections from the Bank represents in a shift in strategy in a more 'dovish' direction, just as other central banks are becoming more 'hawkish'.

In a world where such divergence matters for currencies this leaves the Pound exposed to weakness.