UK PPI Input (MoM) (DEC) (09:30 GMT; 04:30 EST)
Expected: 0.5%
Previous: 1.7%

UK PPI Output (MoM) (DEC) (09:30 GMT; 04:30 EST)
Expected: 0.4%
Previous: 0.5%

What Are The Markets Facing?

With oil and other commodity prices rocketing to record highs, there are well-warranted concerns that global inflation will rise significantly. The prospect of increased price pressures only compounds the problems that the Bank of England already faces as they contend with mounting downside risks to growth and uncertainty surrounding the ongoing reappraisal of risk in the financial markets. With credit market conditions stabilizing somewhat, Bank of England Governor Mervyn King and his monetary policy committee left rates steady on January 10 at 5.5 percent after unexpectedly cutting rates by 25bp on December 6. Nevertheless, the situation for the UK still looks grim as the minutes of the December meeting showed that King – an ardent inflation hawk that is strongly against increasing the risk of moral hazard – voted for the rate cut despite the fact that more accommodative monetary policy may only fan price pressures. Speculation regarding the BOE’s next move may increase next week as UK input and output cost growth is forecasted to slow on a monthly basis. However, PPI input is expected to surge 10.5 percent from a year ago while PPI output is predicted to gain 4.7 percent from a year ago – the sharpest rise in 16 years. The data not only suggests that broad price pressures are mounting, but also that companies are feeling the squeeze on their profit margins as they are unable to pass through the increased costs to their customers. Furthermore, the news will set the stage for the release of CPI the next day, which is anticipated to show that consumer price growth accelerated faster than the Bank of England’s 2.0 percent target once again and could prevent the central bank from cutting rates in February.

Bonds – 10-Year Long Gilt Futures

Gilts have moved to consolidate their gains around the 111 level, as the BOE decision to leave rates steady weighed the contract down slightly. Nevertheless, the BOE’s clear bias remains dovish and UK equities look quite bearish, creating additional upside potential for Gilts. UK event risk on Monday may spark directional price action, as PPI data may suggest that inflation growth is slowing and will set the stage for Tuesday’s CPI report. A slowing in line with expectations could send Gilts up towards 111.25, while a surprising surge may send the contract down for a break below support at 110.56 towards 109.87.

FX – GBP/USD

While the Bank of England’s decision to leave rates steady initially gave the British pound a bump higher as traders had been speculating that they may actually cut rates, the currency eventually continued its descent before finding support. While the trend is clearly to the downside, there are signs that declines for the pair may be slowing, though a drop below 1.95 would target the March 2007 lows of 1.9186. Such a decline may depend more upon whether the markets ramp up their bets that the BOE will opt to cut rates in February, and with Sterling Libor rates picking up once again, the central bank may indeed find it prudent to do so. However, it will be a full month before the BOE meets again, allowing time for Libor to come down, so until then traders will be watching economic data to gauge the chances of another 25bp cut. Next week will provide ample opportunities to judge these probabilities, with PPI, CPI, retail sales, and labor market data all scheduled to be released. If inflation pressures prove to be persistent, this may support the case for GBP/USD gains in the near-term, with a push above 1.9675/85 targeting 1.98. On the other hand, retail sales could prove to be disappointing at the end of the week, which could weigh Cable down below 1.95.

Equities – FTSE 100 Index

The FTSE 100 has run into support near 6,200, though the general trend for the index remains to the downside as the pullback from trendline resistance near 6,500 coincided with a bearish MACD divergence. Monday’s UK event risk could tip the index lower, as slowing producer price inflation may allow the Bank of England room to cut rates in February. On the other hand, the markets may initially take the news in a different way: a rate cut will alleviate instability in the markets. In this case, the FTSE would likely gain, but with central bank rate cuts actually bearish for the stock markets, equity traders may eventually find the index falling towards longer-term support at 6,050 and 5,850.

Terri Belkas is a Currency Strategist at FXCM.