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The First Ashes Test is lost, but things are likely to get worse for those in the UK as the Bank of England readies itself for another hike in its official interest rate on Thursday.
The market is all but convinced the BOE will add another 25 basis points to its cash rate, taking it to 4.75%. But futures pricing indicates there is a growing belief (about one-in-three chance at the time of writing) that the Bank may even go by 50 basis points.
UK CPI another stinker
The BOE will no doubt be concerned by another worse than expected inflation print this week. The Consumer Price Index (CPI) indicated retail prices rose 8.7% for the 12-months to May, unchanged from the 8.7% annual rate in April.
Economists were expecting the annual inflation rate to decline 0.3% in May to 8.4%. Whilst May's result is down from October 2022's 11.1% peak, it is receding painfully slow compared to other major economies and remains well above the BOE's 2% p.a. target.
It's the gradual pace of decline which will concern the BOE the most, as it emphasizes just how much it remains behind the curve in its ongoing fight against inflation.
Watch for potential '6 handle' on BOE rate
There is a common theory among central bankers that the way to control an inflation pulse is to hike the official interest rate above the rate of inflation. This has been achieved in other countries such as the USA and Canada, but it would require further and drastic action from the BOE if they were to pursue and achieve such a goal.
3-month SONIA (Sterling Overnight Interbank Average Rate) futures pricing suggests UK rates could approach 6 per cent by the start of 2024. The current peak rate sits at approximately 5.86%. Doing the math, it implies the BOE would need to increase its official rate by at least 100 basis points after Thursday's most likely rate outcome.
click to enlarge image, source: Chatham Financial
Pound remains currency of choice
Given the UK economy is more of a 'price taker' than a 'price maker' for many basic necessities such as food and energy, it is conceivable the path lower for inflation will be a long and gradual one. It follows, it is equally conceivable the BOE eventually meets market expectations by increasing its cash rate towards 6% by the end of the year.
This is a more aggressive set of outcomes than is expected for most other currency jurisdictions where the process of disinflation is well underway, and as a result, central banks tend to be pausing their current rate hike cycle – or are at least publicly signalling they are considering pausing.
This bodes well for continued Pound strength, particularly against the Greenback whose Federal Reserve chose not to increase official rates at its most recent June policy meeting. The Fed has indicated the possibility of one, or perhaps even two further 25 basis points increases, but many are calling those into question. Either way, the worst-case scenario for US rates remains better than that of the UK.
click to enlarge image
Trading strength in the Pound versus the US dollar makes sense because of the likely relative bullishness of BOE vs Fed hikes, but there's another currency jurisdiction where rates are not only likely on hold for the foreseeable future, but where market rates remain negative. I am of course referring to Japan, where many Japanese Government Bonds are trading with yields below zero. This makes the Yen an obvious funding currency for Pound longs.
click to enlarge image
Market outlook
If the BOE does move by 50 basis points on Thursday, expect the Pound to gain significant further ground against the Greenback and the Yen. However, a move by just 25 basis points may see some profit taking in the GBPUSD and the GBPJPY, as each has been trending higher in anticipation of this week's meeting.
In either case, commentary from the BOE will be crucial as the market will be looking for any signs its assumptions for the future path of rates through the end of 2023 are correct. It is worth noting the market is already expecting rates to top near 6%, so any commentary which suggests this expectation is too high will likely see selling in the Pound, whereas more hawkish comments will likely see continued strength.
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