GBP rallies ahead of BoE inflation report

Ahead of the BoE inflation report

We expect Thursday’s release of the BoE quarterly inflation report to be contradictory at best. This will be the first report issued after the two remaining hawkish members of the Monetary Policy Committee (McCafferty and Weale) gave up their five-month long dissent in favour of interest rate hikes. Against this backdrop and that of plummeting oil prices, the QIR will re-iterate inflation could turn negative in the short-term, but may well surprise markets by indicating inflation could exceed the 2.0% target by the end of the three-year forecast period.

The combination of sterling’s 12% decline and persistent gains in employment may lead the BoE to upgrade its long term assessment on spare capacity. Yet again, it is the BoE’s long-term inflation forecast that is under focus, rather than the near term outlook, which is widely seen coming in below zero.

Sterling reaction

Sterling has been today’s best performer currency ahead of the QIR, which, although will support market expectations that rates would not rise before March 2016, may be followed by a hawkish testimony from BoE governor Carney, whose pronouncements have proven to be more upbeat than BoE reports. Notably, last week’s trifecta of better than expected UK PMI reports (construction, manufacturing and services) highlighted sterling’s status alongside the US dollar as the major currencies whose central banks are not expected to undergo interest rate cuts, unlike in the case of euro, yen, Canadian dollar, Swiss franc, Danish krona and Norwegian krone.

The chart below shows GBPUSD is at the cusp of breaking out of its seven-month long down channel, which was triggered by a combination of weak UK earnings, soft inflation data, pre-Scottish referendum uncertainty and strengthening USD rally. Fundamentally, in order for the GBPUSD to make a definite upside break, tomorrow’s BoE report would have to be sufficiently hawkish to the extent of bringing forward rate hike expectations to 2015, while the US release on retail sales reveals a notable disappointment. An extended rally towards $1.5380 –the 55-day moving average will be the goal for the bulls.