Pound Sterling Hit by Deflation, Weakness Forecast to be Temporary

The pound sterling is under selling pressure as the UK falls into deflation for the first time in decades.

The pound slumped heavily against the US dollar and commodity currencies in the wake of the data release at 09:30. However, solid gains are being experienced against the euro which is under significant selling pressure.

The euro dollar exchange rate is over a percent lower while the euro to pound exchange rate is half a percent lower. It would seem German bund prices have rocketed again confirming that Eurozone money markets are in the driving seat for the time being.

In the UK the ONS reported yearly inflation had slipped to -0.1%, markets had priced the British pound exchange rate complex higher for a reading of 0%. The sell-off reflects currency markets betting on the first interest rate rise in the upcoming tightening cycle being delayed by the Bank of England.

We could well see the first rise come in mid-2016 now. However, the Bank of England last week said they don’t expect this deflation to last and they suggested neither does the British public.

“Today’s news that the UK has entered deflation for the first time since 1960 is unwelcome, but not unexpected. The drop is a result of further, isolated falls in food, fuel and travel but the economy as a whole is still looking relatively strong; if prices were falling across the board we’d have much greater cause for concern,” says Hannah Maundrell Editor in Chief of money.co.uk.

Alan Wilde, Head of Fixed Income at Baring Asset Management notes how the British pound itself may have had a part to play in negative price moves: 

“CPI dipped below zero mainly due to the impact of lower oil prices on the energy sector and to sterling strength. This is unlikely to change the BoE’s view that falling prices is temporary although Service sector inflation declined from 2.4% to 2% which is a useful gauge of domestically generated inflation. This will allow the Bank time to look for signs of incipient wage pressure and may even allow rates to remain unchanged for longer than the market currently prices. Sterling may come under a little selling pressure near term, after the recent post-election bounce.”

Consumers should enjoy cheaper prices while they can - they’re not expected to last. It’s likely we’ll see costs - and inflation - start shooting up by the time we turn our heating back on suggests Maundrell.

Backing the claim that deflation will be temporary is Dennis de Jong, managing director at UFX.com:

“Soaring disposable income figures suggested it was going to be a touch-and-go announcement and the UK has now confirmed a first deflation in over half a century.

“However, Bank of England governor Mark Carney has warned that families will have to make the most of it as this landmark deflation is set to be short-lived. Prices are beginning to recover already and there’s every chance that inflation will be back around 1.5% by this time next year.”

If markets see through these figures we would expect the sell-off in sterling to be short-lived.