Archived IMT (2011.02.16)

FX MARKETS ONCE AGAIN PROVE their forward-looking nature by dragging sterling across the board despite the Bank of England inflation reports upgrade of its short-term inflation outlook to 4-5% while reiterating a sub-2% CPI at the end of the 2-year period. Since the BoE is well aware of its historical tendency to underestimate inflation and overestimate growth, it continues to err on the side of caution.

*** WHAT vs HOW **** While the what is evident; BoE to predict one-off jump in CPI, the how remains unclear. How will BoEs projected slowdown in inflation from 4-5% back to below 2% take place? Will this occur via rate hikes (which are priced in by the market but not officially by the BoE) or will it materialize via the ongoing slack in the economy and austerity policies? And when we remind that the 12% increase in sterling trade weighted since Jan 2009 should dampen the BoEs repeated claims of FX-driven inflation effects--which were mainly a case of the 2007-2009 weaknessthe case for import inflation becomes mute. Figuring out the how to weakening inflation is crucial for FX & bond markets relying on the growth and yield differential play. Yields on both 10 and 2 year gilts are down 5 bps, while the spread between UK & US 2-year yields has weakened (UK minus US) to 0.65%--the lowest in 3 weeks. Sterling eyes more downside against the USD, but is looking the other way against EUR. GBPUSD suffered from a case of lower highs after failing to break above the Feb 7 high of $1.6180. EURGBP bounced off the 0.8360 trendline support but rebound seen capped at 0.8480-00 before the ultimate retreat back to 0.8100 as seen in the chart below.