Will further UK disinflation drive sterling slump?

This week brings a significant focus on UK economic data with the inflation report due out on Wednesday bringing a particular source of volatility for financial markets. The elevated nature of UK inflation has been a driver of sterling outperformance over recent months and there are question marks over whether that will continue once the differentials narrow. That is a particular theme for this week’s inflation report with markets expecting to see another significant decline following last month’s 0.8% drop in the headline CPI reading. The chart below highlights how UK inflation has taken on a similar shape to that seen throughout many of the other developed countries in the world, with disinflation a theme over recent months. However with headline CPI currently at 7.9%, traders are likely to continue considering the monetary policy implications until prices can be brought under control. Last week saw a shock 0.5% GDP reading for June, highlighting the growing feeling that we could see rates higher for longer in the absence of a hard landing.

Expectations for Wednesday’s headline CPI reading signal the potential for another sharp decline, this time bringing the reading down to 6.9% from 7.9% (according to trading economics). Despite this giving grounds for optimism, the market reaction is not always entirely predictable even if we see such a move come to fruition. In part that comes down to the drivers of such a move. Last month’s decline was largely driven by the impact of fuel prices, which is largely a reflection of external factors rather than the implications of policy set at the Bank of England. Therefore Andrew Bailey and his fellow BoE members will be keenly following the trajectory of core inflation as this strips out the more volatile elements such as food and energy. Unfortunately, core inflation looks less encouraging, with last month’s figure of 6.9% only marginally below the 7.1% peak established back in May. The chart below highlights how even the US is struggling to get core inflation back down below 4% as the stickier inflation elements continue to persist.

The inflation report also sees the UK release RPI, PPI, and HPI, bringing a range of ways to look at the UK pricing environment. Notably, we have seen PPI falling sharply around the world, with China in particular exhibiting negative growth in factory prices for much of the past year (currently -4.4%). For the UK this is less helpful than is the case for manufacturing hubs such as the US and Germany. Service sector inflation remains the big issue right now and thus the UK’s reliance on services does highlight the potential for a prolonged period of above target inflation in the UK. Wage growth is one of the core inputs in the service sector, and while the growth of real incomes (CPI below average earnings) is welcome after a prolonged period of declining standards of living, it does raise concerns over continued pricing pressures in the UK services sector.

What about the pound?

The question for traders is going to be around how the pound will respond to this latest inflation report. The key is to focus as much on the core reading as headline inflation. One can quite easily negate the other if they move in opposing directions from market estimates. As such, the release of core and headline inflation above expectations would likely bring further sterling strength. The Japanese yen remains an interesting currency to trade against in the event of a strengthening pound, with low Japanese inflation meaning that any further struggles to drive down CPI in the UK would likely strengthen GBPJPY. With a long-term uptrend in play, the recent breakthrough 184 does signal the potential for further strength here. Should we see inflation come in higher than expected, it is be likely that this pair would continue to push higher following this bullish break. However, a greater-than-expected decline in inflation could put the pound under pressure, with a decline through 183.3 required to signal a wider pullback for this pair.

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