This morning’s data revealed that UK inflation rose to 4.4% in February, a jump of 0.4% on the month, to the highest level since November 2008. In exceeding expectations, the increase in inflation has renewed the possibility of the BoE shifting interest rates, which has helped lift sterling but the market response has still been cautious.
Why? Mervyn King has already warned that inflation will rise towards 5.0% this year, which has taken the edge of an otherwise shocking increase. The figure also failed to realise rumours circulating of an even larger. Perhaps more importantly though, the data is just one of a series of important UK announcements this week, including the MPC’s minutes and UK monthly retail figures. Investors are likely to want a clearer picture of Britain’s economic conditions before taking up positions.
King has set his stall out in past announcements: he has recognised inflation is alarmingly high but asserts that it’s down to temporary factors which will begin to subside within a year. Moreover, King maintains that the dangers posed by a premature rate cut (which could risk pushing the UK back into recession), outweigh those posed by the current levels of inflation.
The market has fully priced in an August BoE rate rise but some are now leaning to a rate rise as early as May. We find this hard to believe even in light of today’s data, though if tomorrow’s minutes reveal an unlikely hawkish recruitment within the MPC, this argument will be far stronger. A rate rise in June remains our view. The pressure really is mounting on the MPC to slow down inflation - they are at risk of losing their credibility - particularly as the ECB are almost certain to embarrass the BoE by raising rates in a fortnight (inflation in the eurozone is only running at 2.4%!).
Following today’s data, sterling is currently trading at a fourteen month high against the dollar (near $1.64), though this has more to do with dollar weakness than with sterling-positive news. Despite a good day, the pound is still struggling against the euro at lows around €1.15. Looking forward, the risks for sterling are actually skewed somewhat to the downside; tomorrow’s UK budget release is unlikely to inspire the markets and the euro may make some more ECB rate hike-related gains - though these may be limited now that such a move has been largely priced in. Investors may also use sterling’s recent gains as an opportunity to take some profit.
What the pound needs is for Thursday’s UK retail sales data to be positive in order to reignite some confidence in the UK’s recovery, which in turn may convince a couple more MPC members that our economy can withstand monetary tightening. However, this seems somewhat unlikely given the forecasted 0.4% monthly contraction.
Richard Driver
Analyst – Caxton FX
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