GBP/USD: Trading the U.K. Consumer Price Report

Trading the News: U.K. Consumer Price Index

Why Is This Event Important:

The headline reading for U.K. inflation is widely expected to hold above the government’s 3% limit for the eighth time this year, and the data is likely to spark increased volatility in the exchange rate as investors weigh the prospect for future policy. The stickiness in price growth could lead the GBP/USD make another run at 1.6000 as Bank of England board member Andrew Sentance sees scope to normalize monetary policy, and members of the MPC may heed to Mr. Sentance’s call as the economic recovery slowly gathers pace.

What’s Expected:

Time of release:10/12/2010 8:30 GMT, 4:30 EST

Primary Pair Impact :GBPUSD

Expected: 3.1%

Previous: 3.1%

Will This Be Market Moving (Scenarios):

Consumer prices in the U.K. are forecasted to increase at an annualized pace of 3.1% for the second consecutive month in September, while the core rate of inflation is projected to fall back to 2.6% after unexpectedly climbing to 2.8% in August. The underlying strength behind price growth could drive the exchange rate higher over the near-term as the central bank stands ready to move monetary policy in either direction, and the data could spark a bullish reaction in the GBP/USD as it maintains the advance from the previous month.

The Upside

Producer prices in the U.K. expanded at an annual rate of 4.4% in September, which exceeded projections for a 4.3% rise, while the core index unexpectedly grew 4.6% for the second straight month during the same period. As the economy continues to recover from the recession, with businesses increasingly their labor force, firms may increase their willingness to pass on higher costs onto consumers as growth prospects improve.

The Downside

However, as households continue to face tightening credit conditions, businesses may look to absorb higher costs as consumers keep a lid on spending. A slower pace of inflation would certainly allow the BoE to expand monetary policy further as it aims to encourage a sustainable recovery, and a drop in the CPI could trigger a selloff in the GBP/USD as investors curb expectations for a rate hike over the medium-term.

How To Trade This Event Risk

As price growth is widely expected to hold above the government’s 3% limit for inflation, price action following the release could set the stage for a long British Pound trade as the BoE pledges to balance the risks for the region. Therefore, if CPI expands at an annual pace of 3.1% or greater in September, we will need to see a green, five-minute candle following the release to generate a buy entry on two-lots of GBP/USD. Once these conditions are met, we will set the initial stop at the nearby swing low or a reasonable distance, and this risk will establish our first objective. The second target will be based on discretion, and we will move the stop on the second lot to cost once the first trade reaches its target in an effort to lock-in our profits.

In contrast, the ongoing slack within the real economy paired with the weakness in the labor market could lead businesses to keep a lid on prices, and a slower pace of inflation is likely to drag on the exchange rate as investors weigh the prospects for future policy. As a result, if the headline reading for price growth slips to 3.0% or lower, we will implement the same setup for a short pound-dollar trade as the long position mentioned above, just in reverse.

Potential Price Targets For The Release

Impact U.K. Consumer Prices has had on GBP during the last month

August 2010 U.K. Consumer Price Index

Consumer prices in the U.K. increased 0.5% in August, which exceeded forecasts for a 0.3%, while the headline reading for inflation unexpectedly held steady at 3.1% for the second consecutive month. At the same time, the core CPI bounced back to 2.8% from 2.6% in July amid projections for a 2.5% print, and the stickiness in price growth could lead the Bank of England to normalize monetary policy over the coming months as inflation continues to hold above the government’s 3% limit. As MPC board member Andrew Sentance continues to dissent against the major and pushes for a 25bp rate hike, other members of the central bank may heed to his call in order to balance the risks for the economy. However, given the substantial amount of slack within the private sector, there could be a three-way split within the BoE as policy makers aim to encourage a sustainable recovery, and the central bank faces increased difficulty in managing monetary policy as it maintains its dual mandate to ensure price stability while promoting full-employment.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario: If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on GBPUSD ahead of the data release.

Bearish Scenario: If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on GBPUSD ahead of the data release.

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To discuss this report contact David Song, Currency Analyst: dsong@fxcm.com