Inflation Bump, Soft Brexit Chat Support British Pound Against Euro, Dollar

• Foreign exchange market quotes:
• Pound to Euro exchange rate today: 1 GBP = 1.1356 EUR
• Pound to Dollar exchange rate today: 1 GBP = 1.2737 USD

Pound Sterling steadied against its main rivals on Tuesday, June 13 following the release of UK inflation data for May which showed another sharp acceleration in price increases.

The ONS reports that an annualised measure of inflation stood at 2.9% in May, well ahead of the 2.7% forecast by analysts.

The monthly reading stood at 0.3%, ahead of the 0.2% forecast.

Core inflation - an important gauge of underlying wage pressures watched by the Bank of England - read at 2.6% having been forecast to read at 2.4%.

This is important - while the headline rate confirms living standards are being squeezed, the core rate suggests there are underlying wage pressures increasing.

The rule of thumb is that a beat on expectation will see the Pound rise, a miss will see it fall with the thinking that the Bank of England will only raise interest rates if inflation is seen to be running ahead of expectations.

Core CPI is a figure the Bank can't afford to ignore as it is now well above the Bank's target of 2% and an interest rate rise must surely be considered.

The consensus view remains that the Bank will ignore inflation in an environment of heightened political uncertainty and signs that the economy is slowing.

“There is limited room of changing monetary policy expectations to the benefit of the GBP. This is especially true as the BoE regards higher inflation as temporary while linking its policy stance to long-term and Brexit related uncertainty. Intact political uncertainty coupled with strongly capped central bank rate expectations should leave the GBP subject to downside risks,” says Manuel Oliveri, FX Strategist at Credit Agricole.

Meanwhile, analyst Paul Hollingsworth at Capital Economics believes we could be witnessing peak-inflation.

"After rising unexpectedly in May, we think that CPI inflation is now not far away from its peak. Indeed, the effects of the lower pound already appear to be fading at the start of the production pipeline," says Hollingsworth in a note following the release of the data.

Regardless of the debate around the economics, for Sterling, the outlook remains hinged on political developments more than economic.

Shifting Towards a Softer Brexit?

We find the most significant development concerning Pound Sterling at present is the idea that the UK could be header for a softer Brexit - i.e. one the could entail some kind of single-market access or customs union membership.

For the Pound, this is a positive if we consider the Pound to Euro exchange rate is now some 13% lower than where it was when the UK voted to leave Europe.

“GBP bulls will cling to the idea that a hard Brexit appears less likely,” says Elsa Lignos at RBC Capital Markets. “But it is too simplistic to assume that the bulk of the Conservative party, which favours single-market exit to control immigration, will roll over and acquiesce."

Nevertheless, recent events have pointed us in the direction of a more flexible approach to Brexit:

1. Headline in The Telegraph today: Tory and Labour MPs pliot secret deal to ensure soft Brexit" - the report starts: "There have also been discussions of a cross-party Brexit Commission to agree common ground between the parties and ensure an orderly withdrawal from the EU."
2. The Conservative supply-and-demand deal with the DUP - we know the DUP is very keen to ensure Ireland doesn’t see border posts erected once more.
3. Irish PM designate Leo Varadkar says he believes the UK is heading for a softer Brexit
4. The Conservatives will rely heavily on the support of Scottish Conservative leader Ruth Davidson who delivered 13 seats in the election
5. A report in the Evening Standard headlined Theresa May sidelined as Tory cabinet 'sensibles' plot soft Brexit is indicative of how the Conservative party itself is shifting

Still Betting Against the Pound

But what is a soft Brexit? Our understanding is that it is a scenario whereby the UK remains within the single market and customs union.

Consider that both Labour and the Conservatives have it in their manifestos that the UK is to exit both the customs union and single market in order to gain control of immigration.

That report from the Telegraph therefore potentially pits the two parties against their manifestos.

The bar to such an outcome remains extraordinarily high.

Analysts at Deutsche Bank are not getting excited about Sterling just yet noting that it is wrong to focus on the binary outcome of a hard or soft Brexit - for them the process is important.

And thus far the signs are not good with political uncertainty pointing to a 'muddled' Brexit process that will weigh heavily on the Pound as it could see the UK run out of time.

“Developments over the weekend have provided sufficient evidence to make the muddle-through strategy we outlined our baseline,” says George Saravelos at Deutsche Bank. “We view this development as particularly negative for sterling and we reiterate our bearish FX view.”

What is for sure is that political uncertainty is on the rise now that the Conservative party are unable to govern with a majority.

RBC Capital Markets are betting against the Pound using the Euro.

“We are tactically long EUR/GBP for the third time in a month, targeting 0.90,” says Lignos.

This equates into a Pound to Euro exchange rate at 1.11.

However, strategists at Morgan Stanley are a little more optimistic on the outlook.

"The market traded political uncertainties with the view that a softening of the British negotiation stance would have no impact of EMU’s negotiation position,a view we disagree with," says Hans Redeker at Morgan Stanley in London. "The Queen's speech will drop the social care tax and maintain the triple lock on pensions. The FT headlines ‘PM urged to support soft Brexit’ combined with fiscal looseness as compared to the original plans suggest GBP support, provided political concerns are replaced by stability."