BOE Quarterly Inflation Report (10:30 GMT; 05:30 EST)
Expected: Hawkish
Previous: Hawkish

US Adv Retail Sales (JAN) (10:00 GMT; 05:00 EST)
Expected: -0.3%
Previous: -0.4%

What Are The Markets Facing?

Rapid gains in oil and other commodity prices have already proved to be a problem globally, as the Reserve Bank of Australia raised rates to an 11-year high last week in order to counter inflation risks. On the other hand, the Bank of England has followed the lead of the Federal Reserve by cutting interest rates in an effort to lessen the blow of a sharp economic slowdown. Indeed, the BOE’s most recent rate cut came just last week, as the Monetary Policy Committee reduced the overnight lending rate by 25bp to 5.25 percent and cited concerns that slowing growth will bring inflation below target, suggesting that more rate cuts may loom on the horizon as long as data points to deteriorating conditions. However, this is not to say that inflation is no longer a concern, and the markets may be reminded of this upon the release of the BOE’s Quarterly Inflation Report on Wednesday. The commentary contained in the November release was quite hawkish and the upcoming print is unlikely to be much different, especially following Monday’s UK PPI figures which showed input and output costs at the factory gate rocketing higher during January. While this was primarily the result of oil hitting a record high of $100.09/bbl on January 3, indications that businesses will start passing these rising costs onto consumers does not bode well for the containment of price pressures in coming months. If the Inflation Report is as hawkish as we anticipate, the markets may quickly reduce bets that the BOE is ready to aggressively slash interest rates. Later on Wednesday morning, US Advanced Retail Sales are forecasted to fall for the second consecutive month, which will only reignite speculation that the country is nearing or is already in recession. With consumption composing roughly two-thirds of US economic output, the retail sales report can be particularly market-moving and will be key to gauging the Fed’s next move. Fed fund futures are still pricing yet another 50bp rate cut to 2.50 percent in March, and if all signs in the US continue to point towards recession, there is little doubt the markets will get what they’re counting on.

Bonds – Long Gilt Futures

Gilts are looking increasingly bearish as the contract falls back towards trendline support at 110.00, and the January 22 daily candle hints at a sustained turn lower. Indeed, upcoming UK data may help weigh Gilts down as well as the BOE Quarterly Inflation Report is anticipated to contain a hawkish tone. On the other hand, a return to risk aversion in the markets could help buoy Gilts.

FX – GBP/USD

Hawkish sentiment is still in the air in the UK, even as the Bank of England followed the lead of the Federal Reserve by cutting interest rates by 25bps to 5.25 percent last week. Given Monday’s hot PPI figures, all eyes are on the BOE’s Quarterly Inflation Report to see whether upside risks to price stability remain the prevailing concerns of the Monetary Policy Committee. While there is little doubt that the central bank is worried about dim growth outlooks for 2008, rate cut expectations for the BOE may be a bit overdone. As a result, if the Quarterly Inflation Report shows that the MPC forecasts even stronger price pressures in coming months, the markets may take this as a hint that rates will be left unchanged in March. As if this isn’t enough to create upside risks for the GBP/USD on its own, US retail sales are anticipated to fall for the second consecutive month. If Wednesday’s data is released in line with expectations, the prospects of a neutral BOE policy stance and an increasingly dovish Federal Reserve could lead GBP/USD to continue to climb towards 1.9650.

Equities – FTSE 100 Index

The FTSE 100 continued to trade close to support near the 5,700 level amidst multiple UK inflation-related releases this week. Monday’s stronger-than-expected PPI figures and robust commodity price growth over the past few months suggest that the Bank of England will remain hawkish in Wednesday’s Quarterly Inflation Report. The news will be disappointing to those hoping for yet another round of rate cuts in March, as traders ramped up speculation of such a move after the BOE’s policy statement last week suggested that the downside risks to growth were of greater concern than inflation. Nevertheless, price stability remains a mandate of the MPC, and persistent inflation will likely force the central bank to take a more measured approach to making monetary policy more accommodative. Meanwhile, counter to what some believe, the rate cuts have done little to help boost shares in the UK – as the Federal Reserve rate cuts have not helped US equities – and with the Bank of England remaining open to additional reductions in the overnight lending rate, the FTSE 100 may have far lower to fall.

Terri Belkas is a Currency Strategist at FXCM.