Bank of England Inflation Report Caps British Pound Gains

The week’s main focus for the British pound is Wednesday’s quarterly inflation report and the accompanying press conference conducted by BoE Governor Mark Carney.

Sterling has fallen back from the year's best levels against the US dollar following the BoE’s Inflation Report - this tells us that the message being absorbed is that the first interest rate rise could occur towards the back-end of forecasts which are currently placed in mid-2016. This will disappoint those who had priced sterling higher for a potential increase in 2015.

“BoE cuts growth forecast for 2015 from 2.9% to 2.4%. Interest rates to start rising in mid-2016,” says a reaction from economic survey publishers Markit. The downgrade to growth forecasts comes alongside a tone that suggests UK productivity is still yet to reach the 'exit velocity' needed to justify a rate increase.

All those solid post-employment data gains have pretty much been undone but we remain of the view that the fundamental economic picture in the UK will continue to underpin the currency.

Carney also took the opportunity to warn on the strength of the British pound. Could the Bank be delaying or ‘talking back’ an interest rate rise to target the strength of sterling? The answer is yes - the strength of sterling is incorporated in financial forecast models and any headwinds posed by the GBP are therefore factored into the timing of interest rate rises via the economic forecast models.

We would believe that the Bank of England will be keeping the pound in mind with regards to its timing and communication on interest rate strategy.

Above: Bank of England sees slightly lower growth rates ahead.

In terms of inflation Carney has said he does not expect inflation to remain low for too long. Furthermore, he believes the British people have the same view - the Bank sees no evidence that people are delaying purchases, and thus undermining economic growth, in anticipation of yet lower prices.

The Bank, and the people, therefore see higher inflation ahead. We see this view as underpinning GBP and preventing any major sell-off.

We Were Warned This Would be GBP Negative

For currency markets policy concerning interest rates is arguably the single most important factor when it comes to direction. Those currencies that out-perform their rivals are those supported by higher interest rate yields – global money flows to those countries where better returns are offered.

The dollar has rallied in admirable fashion over the past year thanks to expectations for higher US interest rates, and the same expectations can be attributed to pound sterling strength.

However, both the dollar and pound are regularly sent lower when markets perceive the timing of the first interest rate to have been pushed further back. The opposite is true when good data prompts markets to guess that the timing of the rate will be brought forward.

The thinking of the decision-makers at the Bank of England will be made all the more clear on Wednesday the 13th of May with the second inflation report of the year.

“The May Inflation Report is likely to include downward revisions to its near-term inflation and GDP forecasts, given recent disappointing data,” warns an economic note issued by Barclays ahead of the event. We see any such downward revisions as being a negative for the pound exchange rate complex.

This view is echoed by professional trader Kathy Lien at BK Asset Management who cites mixed U.K. data, low commodity prices and concerns about fiscal austerity as setting the ground for a more cautious report.  "If the BoE maintains a neutral outlook that places equal emphasis on the upside and downside risks, sterling will give up its gains quickly," says Lien.

While the April BoE MPC meeting minutes emphasised upside risks to medium-term inflation, it remains the case that no MPC member is currently voting for a rate hike and within this group, BoE Chief Economist Andy Haldane likely continues to see risks of a rate cut.

“As such, Governor Carney may indicate a degree of comfort with current interest rate market pricing, which implies the first BoE rate hike in Q2 16,” say Barclays confirming their own forecast is later than current market pricing.

If the markets are forced to adopt a similar view to these analysts then the GBP could well come under pressure.

Election Outcome Allows Bank of England to Stay Unmoved on Rates

A similarly negative stance is proposed by analyst George Buckley at Deutsche Bank.

Deutsche Bank have pointed to the recent elections and the impact they may have on the Bank of England’s thinking. “We don’t expect a Conservative government to do much more in the way of austerity than announced in the coalition Budget two months ago,” says Buckley.

The intention is to cut the structural deficit by 1% per year on average over the coming parliament. However, this is more than a Labour government would have been willing to do and “as such may mean that the Bank of England leaves interest rates on hold for longer than would have been the case had the opposition won this election (we believe the Bank will start to tighten from May next year),” says Buckley.

While we have heard two GBP-negative stances, we would point out that the economy continues to grow at a decent pace with wages rising and unemployment falling. These solid fundamentals should ultimately keep the timing of the first interest rate within the ball-park of late 2015 and the first half of 2016.

We therefore would need a significant downturn in the UK’s economic data series to push expectations out of this range – we are yet to see such a scenario.

As such we would suggest any weakness in sterling will likely be short-term in nature.