Forex Trading Library

Inflation Could Leave Pound King of the Currencies

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Last week’s UK CPI and the results of the BOE left the pound in a somewhat unique situation. The more pressing matter for traders is trying to figure out if there will be a rate cut at the next meeting. But a broader view of the major currencies and how their inflation has been performing provides an intriguing perspective.

Even when the BOE gets around to easing, it could still be the most “hawkish” of the majors out there. When considering inflation into the mix, the pound could end up having among the strongest fundamentals, on par at least with the greenback. Though the situation might not last long (as in, a few months) it could provide substantial upside for sterling through the rest of the year.

What Happened?

Let’s rewind a couple of years. Back when inflation was starting to get out of hand, the BOE was the first of the major central banks to start tightening. This gave the impression it would be the first to curb inflation – but, the opposite happened, as Thread needle Street was reluctant to tighten and UK CPI change became the highest among the majors. Since then, however, the UK has seen the fastest drop in inflation. Unlike its peers, such as the US and the Euro Area, it did not avoid a technical recession.

As a result, other major currencies are seeing inflation sort of settle just above the target rate. That would keep the possibility of easing on the backburner. The US’s uptick in inflation through the second quarter was significant enough to raise the possibility of the Fed sticking it out until the end of the year before cutting. The BOE did not have this problem. Although the core rate remains high, it is falling at a much faster rate than in the US or Europe. And headline inflation last month already fell back to target.

Keeping it Real

What this means is that the highest real interest rates (that is, the interest rate taking into account inflation) are in the UK, which theoretically should attract more investors. That would prop up the pound. Even as central banks including the BOE move towards easing, the BOE is “behind” the curve, giving it a more restrictive stance.

Restrictive rate policy is bad for the economy, but it generally increases demand for debt denominated in that currency as investors look for the best yields. Those yields can be maintained even if there are interest rate cuts, if the inflation rate falls at a similar level. That means that if the inflation rate falls by the same amount as the interest rate, then the real rate stays unchanged.

Can the Trend Continue

If the UK manages to keep a lid on inflation and the core rate keeps falling as it has been doing so far this year, then Britain could end up with the lowest inflation of the major economies. Giving it, by extension, the strongest currency. This could be especially true for the GBPEUR, if the ECB is forced to keep easing to support the economy while inflation remains slightly above target – as the shared central bank is predicting for the rest of the year.

Now, of course if inflation falls too fast, then the BOE could turn around and start cutting even faster than it hiked. But as long as core inflation remains elevated and the labor market is tight, the UK could offer investors the best real returns, and boost the pound.

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