UK CPI Drop Adds Pressure on BOE

The BOE looks set to keep hiking despite economic indicators. The dissonance could weigh on the pound as traders look for economies less threatened by a recession.

It's the Meeting After that's the Concern

Markets are pricing in an 80% chance that the BOE will hike by a quarter of a point when it meets tomorrow. This means that barring surprises, the focus will shift to what Governor Andrew Bailey has to say in the post-rate decision presser because there is considerably more uncertainty about what will happen afterwards. After the UK economy contracted more than expected in July, some analysts think that the BOE hawks are running out of time to raise rates before the UK economy tips over into some kind of hard landing.

Meanwhile, the UK maintains the highest interest rate among major economies. The head of the BOE has repeatedly said that the inflation rate will fall fast soon, implying the rate hiking cycle has ended. But for cable bulls, the worry is that a sudden drop might have more to do with a recession than a stabilising economic situation. Earlier data today showed a somewhat sudden drop, with both headline and core falling substantially below forecasts.

Adjusting Forward Guidance

Nearly all economists in a recent Reuters poll saw the risk of inflation being skewed to the upside. Despite this, a small majority think that rates will top out at the next meeting when they reach 5.5%, for a total of 540 bps of hikes since the cycle began. The rest saw a peak of 5.75% or even higher. This division is reflected in the members of the Monetary Policy Committee, with the Governor suggesting that the bank was near the end of hiking. At the same time, Catherine Mann, who has voted for hikes consistently in the past, insisted on erring on the side of tightening, given the high inflation rate.

The wording concerning the trajectory of future hikes is likely the main driver of market reaction. A clear suggestion that rate hikes aren't over would likely lead the consensus to shift towards a higher peak rate. But whether that will support the pound is another question because the increased risk of an economic contraction could make investors more wary of investing in the UK. Or the BOE could take its cues from the ECB, which last week suggested that rate hikes were likely over. A more neutral stance could convince more traders that the peak has been achieved, and the pound could weaken pending further economic data.

Cable to Double Bottom?

Cable slid to a May low of $1.2334 early Wednesday following the drop in CPI, opening the door to $1.23 in the short term. A potential move there could form a double bottom, which could be seen as an opportunity for either a reversal or short-term respite towards $1.2548. If the latter gives in, the chances of rising towards $1.28 will increase. If not, or if no notable attempt is made towards it, the risk of further declines will increase, with a failure to hold the low exposing the next handle at $1.22.

Source: SpreadEx / GBPUSD

Key Takeaways

The UK's drop in CPI adds pressure on the Bank of England (BOE) to make a decision. Despite economic indicators, the BOE is expected to raise rates, which could affect the pound's value. The concern lies in what the BOE Governor will say after the rate decision, as there is uncertainty about future actions. The UK currently has the highest interest rate among major economies, but some worry that a sudden drop in inflation could indicate a recession. Economists are divided on the trajectory of future rate hikes, with some suggesting the end is near while others anticipate further increases.