Pound Slips against Euro and Dollar after July Inflation Data Underwhelms Market

-UK consumer price index rises from 2.4% to 2.5% in July, core steadies.

-CPI increase insufficient for markets to contemplate next BoE rate hike.

-GBP slips, remains vulnerable to losses amid ongoing Turkish crisis.

© IRStone, Adobe Stock

The Pound reversed course and slipped lower against the Dollar Wednesday after official data showed UK inflation rising only a fraction during July, when some analysts and economists had pencilled in a larger increase. 

Consumer prices rose at an annualised pace of 2.5% in July, up from 2.4% in June, which was in line with the consensus forecast of economists.

The core consumer price index, which ignores volatile food and energy items so is seen as a more accurate representation of domestically generated inflation pressure, held steady at 1.9%. Also in line with expectations.

Rising prices for computer games and transport fares were the main contributors to the increase in inflation, but were partially offset by a fall in the price of clothing and footwear, according to the Office for National Statistics.

"The increase, from 2.4% in June to 2.5%, was in line with both our own forecast and the consensus expectation. Note though, that it was still a touch below the 2.6% expected by the Bank of England," says Andrew Wishart, a UK economist at Capital Economics. 

Markets care about inflation because it has implications for interest rates, which are themselves the predominant driver of exchange rates because of the influence that rising and falling returns can have on international capital and speculative money. It is inflation that central banks are attempting to manipulate when they tinker with interest rates.

Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"We still think that a fall back in oil prices and the ongoing reduction of the impact of the 2016 sterling depreciation will allow inflation gradually ease to 2% by the end of 2019. As a result, while real wages have started to recover, inflation is likely to prevent them from recording substantial increases, weighing on households’ finances and consumer spending," Wishart adds.

The Bank of England raised its interest rate to 0.75% in August, citing its own inflation forecasts that suggest the consumer price index will remain consistently above the 2% target over coming years. It also says rising levels of household pay will stoke even further inflation pressures during the quarters ahead.

This was the second rate rise inside of the last 12 months, although markets have since been reluctant to bet that another will be delivered any time soon, due largely to uncertainty over the trajectory of the Brexit negotiations and the impact that an eventual EU exit might have on the economy.

"Today’s data follows the jobs data that revealed a similar story to the US – a drop in the unemployment rate to 4.0%, the lowest level since 1975 but it was accompanied by weaker than expected wage growth," says Derek Halpenny, European head of global markets research at MUFG. "We still see scope for some strengthening of wage growth going forward and the data provided the justification for the action taken by the BoE at the start of this month. Again though, Brexit uncertainty and general dollar strength will limit GBP/USD upside over the short-term.

The Pound was quoted 0.05% lower against the Dollar at 1.2713 following the release Wednesday, after reversing an earlier fractional gain, while the Pound-to-Euro rate was up 0.14% at 1.1222.

Sterling was also higher against all other developed world currencies, marking an about turn from several days worth of steep losses for the currency.

Capital Economics' Wishart is not the only observer to forecast that UK inflation will fall toward the end of 2018 and next year, as the Pantheon Macroeconomics team also expect consumer price index to drop below the 2% target in 2019. 

"Below-target inflation won’t rule out rate hikes—the current rate of core inflation has been below 2% on 20 of the 22 occasions since 1997 when the MPC has hiked rates—but it will give the Committee plenty of breathing space and allow it to hold back from raising rates again until the economy materially speeds up," says Sameul Tombs, chief UK economist at Pantheon. 

Financial markets, including those in the UK, have been rocked this week by an ongoing currency crisis in Turkey, which now threatens to evolve into an all-out financial crisis.

Given the UK's large financial sector, as well as its reliance on funding from overseas investors, Pound Sterling has found itself under increasing pressure since Friday, 10 August. The Pound-to-Dollar rate has fallen from 1.2896 on Thursday, 09 August. 

"GBP is playing second-fiddle to events in EM and the strong dollar right now. The UK’s large current account deficit and exposure to the financial sector typically sees GBP trading as a risk sensitive currency, warning of downside risks in GBP/$ given the current climate. Cable could see 1.2600/2620," says Chris Turner, global head of FX strategy at ING Group.

Turkey's Lira has been clobbered on currency markets, falling 17% on Friday and by 82% against the US Dollar this year, as markets fret over an escalating dispute between Ankara and Washington, a politically compromised central bank and deteriorating economic fundamentals.

Those fears spilled over Turkish borders and into Europe Friday as traders panicked about the exposure the continent's banks have to Turkish borrowers, whose foreign currency debts and interest payments have almost doubled this year.

"A textbook currency crisis is unfolding in Turkey. Large and widening current account deficit, check. Growing foreign currency debt, check. High and rising inflation, check. Constrained monetary policymaking, check. The one key difference is the absence of an exchange rate peg," says Kit Juckes, chief FX strategist at Societe Generale. "Just as King Canute could not stem the waters by ordering the tide to stop, a country with a 6% current account deficit and 15% inflation will be powerless to stop its bonds and currency sliding without hiking interest rates and/or restricting capital outflows."

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