Does Peak Inflation = Peak Pound Sterling?

The recent rise in inflation to 3.0% represents a peak argue analysts at Bank of America Merrill Lynch who see an extended decline ahead, which could take the Pound with it.

At 3.0% in October, inflation is peaking and ready to decline, says Bank of America Merrill Lynch (BofAML), and according to the logic of financial markets, the Pound is also probably peaking and set to fall along with it.

Lower inflation tends to weaken a currency; higher to strengthen it, but not because of inflation per se, rather because it tends to lead to higher interest rates, and these - not inflation - push up the value of the currency.

Interest rates are set by central banks - the Bank of England in the UK - who tend to raise them as a response to higher inflation, in order to bring it back down.

One by-product of higher interest rates is that they attract higher inflows of foreign capital from global investors seeking somewhere where their money can earn more interest; and these higher inflows increase demand for the currency, increasing its value.

Yet if inflation is set to roll-over the BOE is unlikely to raise interest rates and this takes one major up-driver of the Pound out of the valuation equation, suggesting if anything a neutral or lower outlook for Sterling.

Sterling: Inflation's Culprit and Victim

The reason inflation has peaked and is about to move lower is actually due to the effect of the Pound - or rather the weak Pound waring off.

Previously the weak Pound (as a result of the referendum hit to Sterling) caused inflation to rise by increasing the price of imports, but now that the Pound is stronger, the inflationary effect of the weak Pound has steadily worn off, albeit with a considerable lag.

"Sterling's boost to UK inflation probably peaked in October, given inflation surprising a little on the downside at 3.0% in October (consensus e. 3.1%)," says BofAML UK Economist Robert Wood.

The considerable rise in inflation from below 1.0% to the most recent 3.0% recorded in October has almost entirely been caused by the weak Pound.

This is proven by the fact that domestic service sector inflation has barely changed since 2015 - all the inflation has come from expensive foreign imports.

"Inflation rose to 3.0% only because of currency effects: services inflation was lower this month than in December 2015, when headline inflation was 0.2%," says Wood.

Now that the Pound is stronger, these effects will fade pushing inflation back down to below the Bank of England's 2.0% target by the last quarter of 2018 argues Wood.

Although BofAML think the peak in inflation has already been reached, a final push higher is also possible in November, they say, due to the recent rise in oil prices.

However, beyond that they do not see any further rises, and inflation will steadily decline from its new peak of 3.1% or 3.2% - as oil will also, presumably, not rise either.  

The end result of all the theorising about inflation is that the BOE will not need to raise interest rates next year despite the market currently expecting them to raise rates once in 2018 and once in 2019.

"The sharp inflation drop we expect next year should keep the BoE from hiking rates again, we think," says Wood.

And without the oxygen of higher interest rates, it is not a huge leap to suggest that the Pound will lose its glow as well, especially given markets are expecting two more interest rate hikes in 2018 and 2019, and that expectation will be priced into Sterling already.

Outlook Negative for the Pound in 2018 - But Beyond?

In short, we conclude from BofAML's research that if they are correct about inflation the Pound is set to turn down at the end of the year and be capped by falling inflation data during 2018.

Indeed, BofAML's forecasts for the Pound vs. Dollar see the exchange rate falling to around 1.29 in the first quarter of 2018 before nudging up towards ~1.32 for end-2018.

The Pound vs. Dollar exchange rate is forecast at around 1.12 in the first quarter of 2018 and 1.11 towards the end of 2018.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.