The Next FX Play: Long Sterling

Lior Alkalay - Contributor - Forex

This week is expected to be a choppy one for the Pound Sterling. On Thursday, the Bank of England is set to publish its quarterly Inflation Report alongside the BoE rate decision. FX investors want to see if, afterward, a more hawkish picture emerges. If that’s the case, Sterling could quickly move higher against its battered peer, the Euro.

What to Watch for in the Inflation Report

Essentially, there are three different points worth watching in next week’s Inflation Report.

• The first are global risks. In August’s Inflation Report, the BoE warned of downside risks to inflation from global weakness. Yet after the Fed dropped its own warning on global risks, the BoE may follow suit. That will, of course, be the first hawkish sign.

• The second would be the risk of imported inflation or, in this case, disinflation. The BoE has justifiably warned of the consequences of a weak Euro. Many UK imports come from the Eurozone, and the Eurozone is a key export destination. Thus, a weak Euro weighs on UK inflation by lowering prices of goods within the UK. If the Bank sees this risk as more muted, that’s a positive sign. Although with chances of additional ECB stimulus increasing it’s hard to see a change to this segment.

• The third would be inflation expectations. Of course, it all does eventually narrow down to inflation expectations. In its past report, the BoE had expected downward inflationary pressures would gradually recede in the second half of the year. Is this scenario still intact? If, over the past quarter the BoE still sees the risk of deflation diminishing, that’s another hawkish arrow. It’s also another sign that the BoE, although at a somewhat slow pace, is moving toward high rates.

Reasons to be Upbeat

Generally, markets are optimistic on the chances of UK inflation stabilizing and the BoE turning more hawkish. The reason is the dissonance between wage gains and inflation. The chart shows that core inflation (which neutralizes seasonal and external factors) has lagged wage growth. Meanwhile, UK retail sales growth has remained robust, growing at 6.5%. This suggests that Britons are earning more and spending more. That, eventually, has to translate into higher inflation. Continue reading "The Next FX Play: Long Sterling"