Pound Strength May Continue If Inflation Data Fuels Interest Rate Expectations

GBP/USD

The pound/dollar has come under pressure as a pullback in risk appetite has fueled bullish greenback sentiment. The pair’s correlation with stocks remains the main driver of price action with a 25% influence. Soaring equity markets sent the pair to a three month high before recent weakness. Markets thirst for higher yields doesn’t appear to be quenched which leaves potential for more bullish potential. Meanwhile, interest rate expectations can’t be dismissed in forecasting direction as they continue to grow in importance explaining 24% of volatility, up sharply from 13% a month ago. The BoE refraining from adding to their asset purchase program has shortened the timeline for future tightening, increasing its importance.

BoE Interest Rate Expectations

Interest rate expectations for the U.K. have fallen following the BoE’s rate hold as the central bank has left the door open for additional quantitative easing measures. However, today’s release of the October consumer price report may start to increase the outlook for future tightening. Inflation rose for the first time in eight months to 1.5% surpassing estimates of 1.4% with the core reading rising as well to 1.8% from 1.7%. BoE committee member Andrew Sentance said Britain is returning to growth and risks stoking inflation if it maintains stimulus efforts for too long. Markets may start to price in additional tightening from the central bank which could reignite bullish sterling sentiment. Yet, the central bank has maintained their forecast that inflation could take a circuitous path before hitting its 2% target by mid-2010. Therefore, unless a pattern of rising price develops it may not have a significant impact on yield forecasts.

FOMC Interest Rate Expectations

Fed Chairman Ben Bernanke comments yesterday have slightly raised interest rate expectations with Fed Funds futures now pricing in a 7.0% chance of a rate hike in January with odds in March rising to 16.7%. A deeper than expected drop in U.S. inflation and a slower pace of industrial output furthered the central banks case for maintaining rates at low levels. Core producer prices tumbled to 0.7% from 1.8% which set eh stage for consumer prices to follow. A 0.1% rise in activity missed expectations of 0.4% and was significantly slower than 0.6% in September. The manufacturing sector has been the catalyst for recent growth as companies continue to restock depleted inventories. A lack of consumer demand will dramatically slow output and with unemployment reaching 10.2% expectations are low for domestic growth.

Risk

Equity markets shrugged off earlier weakness derived from the weak industrial production figures leaving the door open for a test of resistance at 1156.60-76.4% Fibo of 13,136-6469, where we also see former congestion. However, equity markets still remain vulnerable to a retrace as fundamentals start to reinforce concerns over future growth. Risk appetite doesn’t have the same influence on the sterling as other majors but it is still the main driver of overall volatility and must be taken into account.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com