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

Trading the News: U.K. Consumer Price Index

What’s Expected:

Time of release: 03/22/2011 9:30 GMT, 5:30 EST

Primary Pair Impact:GBPUSD

Expected: 4.2%

Previous: 4.0%

DailyFX Forecast: 4.1% to 4.3%

Why Is This Event Important:

Consumer prices in the U.K. are forecasted to grow at an annualized pace of 4.2% in February, and the faster pace of inflation could spark a bullish reaction in the British Pound as market participants speculate the Bank of England to gradually normalize monetary policy over the coming months. At the same time, the core CPI is projected to climb 3.1% from the previous year, and the BoE meeting minutes could reveal a growing shift within the MPC as the central bank pledges to deliver on price stability. In turn, speculation for higher borrowing costs could lead the GBP/USD to make another run at 1.6400, and the pound-dollar may continue to retrace the decline from back in 2009 as interest rate expectations gather pace.

Recent Economic Developments

The Upside

The Downside

As growth accelerates, with firms increasing their rate of production, businesses may widen their willingness to pass on higher costs onto consumers as private sector activity improves. However, as economic activity unexpectedly contracts in the third quarter, with household sentiment slipping to a record-low in February, businesses may look to absorb higher costs in an effort to generate domestic demand. In turn, a slower rate of inflation would certainly allow the BoE to maintain the expansion in monetary policy, and the central bank may look to support the real economy throughout the majority of 2011 as it aims to encourage a sustainable recovery.

Potential Price Targets For The Release

How To Trade This Event Risk

Forecasts for a higher rate of inflation certainly reinforces a bullish outlook for the sterling, and the market reaction to the consumer price report could set the stage for a long British Pound trade as investors speculate the BoE to normalize monetary policy in 2011. Therefore, if the headline reading for inflation advances 4.2% or greater in February, we will need a green, five-minute candle following the release to establish 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 after taking market volatility into account, and this risk will generate our first target. The second objective will be based on discretion, and we will move the stop on the second lot to breakeven once the first trade reaches its mark in order to preserve our profits.

In contrast, the deterioration in household sentiment paired with the unexpected contraction in 4Q GDP may lead businesses to keep a cap on consumer prices, and a slowdown in price growth could bear down on the exchange rate as investors scale back speculation for higher borrowing costs in the U.K. As a result, if the CPI advances less than 4.2%, we will carry out the same setup for a short pound-dollar trade as the long position mentioned above, just in the opposite direction.

Impact that the U.K. Consumer Price report has had on GBP during the last month

January 2011 U.K. Consumer Price Index

The headline reading for U.K. inflation increased to a 26-month high of 4.0% in January following the rise in the value-added-tax rate, while the core CPI climbed to 3.0% during the same period amid forecasts for a 3.1% print. The breakdown of the report showed food prices climbed 6.2% from the previous year, with prices for clothing and footwear advancing 9.8%, while energy costs increased 2.4% during the same period. As price pressures intensify, the Bank of England may see scope to gradually normalize monetary policy later this year, and there could be a growing shift within the MPC as the central bank’s ability to ensure price stability comes under increased scrutiny. However, as the new coalition in the U.K. takes extraordinary steps to curb the budget deficit, the tough austerity measures are likely to bear down on the recovery, and the central bank may retain its wait-and-see approach throughout the first-half of 2011 as it aims to balance the risks for the region. Indeed, currency traders showed a bearish reaction to the in-line print as the GBP/USD slipped below 1.6020, but the British Pound regained its footing during the North American trade as the pair ended the day at 1.6121.

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