GBP/USD Rate Surges on "Game-changer" U.S. Inflation Data

• U.S. inflation flatlines in July
• Signals potential for peak Fed hike expectations
• USD sells off as a result
• But economists warn inflation to remain sticky
• And the Fed to remain hawkish
• Potentially limiting USD weakness

Image © Adobe Images

The Pound to Dollar exchange rate rose by over a percent on the day to 1.2214 after U.S. CPI inflation rose 8.5% in the year to July, coming in below June's 9.1% and the consensus expectation for a reading of 8.7%.

U.S. core CPI rose 5.9% in the year to July, unchanged on June, but below the 6.1% the consensus was looking for.

The Dollar fell as investors bet the peak in inflation might have passed and therefore the need for the U.S. Federal Reserve to pursue an aggressive policy of interest rate rises had lessened.

"Game-changer US CPI report!" says Viraj Patel, Macro Strategist at Vanda Research. "It's only one print but this bucks the trend of persistent price rises... core coming in softer."

The U.S. effectively recorded no inflation last month with a month-on-month reading of 0%, which is below the +0.2% read the market was expecting.

Above: GBP/USD at five-minute intervals.

The Dollar has been bid through the course of 2022 in part because the Fed has lead its global peers in pushing interest rates higher.

Passing 'peak Fed' expectations could therefore imply 'peak Dollar' is in. "Maybe Powell was right to pivot a few weeks ago. Certainly takes pressure of Fed to be aggressive in Sep. Long duration trades will rally hard for now," says Patel.

"Lower US inflation has swung the odds back in favour of a 50bp Fed interest rate hike in Sep rather than 75bp, but there is a lot of data to come between now and then," says James Knightley, Chief International Economist at ING Bank.

The Dollar's agreement to this interpretation was abundantly clear as it fell against all its peers:

Above: USD relative performance on Aug. 10, image: Pound Sterling Live.

The Pound to Dollar exchange rate rose to a high of 1.2250 in the minutes following the release, taking the quotes on bank accounts for pound into dollar payments just back above 1.20 again for the first time since last week.

The quotes from independent payment providers were meanwhile coming in back above 1.22 according to our dashboards.

"Finally some good news on the inflation front. We've likely seen the inflation peak," says Justin Wolfers, professor of public policy and economics at the University of Michigan.

However, some economists warn it is too simplistic to assume inflation is about to fall sharply back to the Fed's ~2.0% goal.

"But the stickiness of core inflation highlights challenges of tempering inflation in the parts of the CPI basket which are slow to change," says Hussain Mehdi, Macro and Investment Strategist at HSBC Asset Management.

He says services inflation will prove to be a thorn in the side of the Fed as consumers rebalance consumption away from goods into services, and amid rising shelter costs.

Furthermore he notes spending to be underpinned by a very robust jobs market.

"All in all, the Fed is set to remain very hawkish, and will be forced to push rates into restrictive territory, a process that may continue into the new year. This alongside squeezed profits, reduced hiring/job layoffs, and weak confidence, is likely to trigger recession," says Mehdi.

HSBC Asset Management maintains a defensive and selective investment strategy with investors potentially overestimating 2023 earnings performance and the ability for the Fed to enact a policy pivot.

If correct, this would be consistent with ongoing Dollar strength.

Also warning against betting that inflation is 'over' is Christoph Balz, Senior Economist at Commerzbank who says the decline in headline U.S. inflation is driven by falling gasoline prices, a response to falling global oil prices.

"The further decline in the inflation rate is therefore likely to be slow," he says. "Although we can breathe a little easier after today's data, the inflation problem is likely to prove very persistent."

Commerzbank expects U.S. inflation to remain above 3% in the course of next year, despite a recession.

"Initial reaction sees US dollar selling off hard down 1% vs EUR and GBP," says Mike Owens, Global Sales Trader at Saxo Markets, "these moves may be short lived if the market returns its attention back to the Fed, one month of data won't change their current hawkishness as it stands by its mission to force inflation down."