What Are The Markets Facing?

U.K. factory gate prices are expected to increase to 7.7% in May from 7.5% the month prior. Prices have already reached the highest levels since 1986 as energy and raw material costs continue to squeeze manufacturer’s margins and are forcing them to pass more costs onto consumers. If the release prints inline or hotter, then the chances of the BoE increasing their benchmark rate in the near-term will increase significantly, as inflation already stands at the central bank’s 3% threshold. Governor King may follow his counter parts ECB president Trichet and Fed Chairman Ben Bernanke and signal future rate hikes. The upcoming BoE minutes and the next inflation report may show the MPC is on the verge of a rate increase, despite the continued weakening of the U.K. economy. The country has seen contraction in its service industry which accounts for 75% of GDP. Also, housing continues to deteriorate with the RICS house price balance expected to show further declines latter in the day, following the producer prices release. Additionally, credit markets remain tight and fallout continues from the subprime crisis. The policy meeting before last saw a near unanimous decision to leave rates unchanged. Therefore, it wouldn’t be surprising if at the last decision there were calls for a rate hike.

Bonds – Long Gilt Futures

Gilts were weighed lower by the BoE keeping rates unchanged, as they focus on inflation. The prospect of a future rat hike increased when Trichet and Bernanke signaled that global inflation is too big a problem to ignore further and that central banks may need to take action to stem the effects of record levels of food and oil prices. Upcoming PPI numbers are expected to increase which will confirm Governor King’s concern that inflation will remain above 3% for the remainder of the year. A rise in factory gate prices should weigh bonds lower as the possibility of a rate hike increases. Conversely, easing prices may signal that slowing growth will dampen inflation going forward and allow the MPC to focus on stemming a recession and send Gilts higher.

FX – GBP/USD

The GBP/USD remains in a longer term downward trend channel. However, the pair is looking to test the upper trend line as it has found support on the back of a BoE rate hold and a negative U.S. NFP report. Despite, the country seeing manufacturing, construction and services all decline to or near contraction, the possibility of a future rate hike by the BoE is increasing. The sterling will continue to gain strength as the central bank becomes increasingly hawkish. Indeed, technical analyst Jamie Saettele is calling for a pound rally with a target above 1.9850 against 1.9461 in his technical report. Increasing producer prices will lend support to his argument as the MPC may not be able to ignore the long-term effects of inflation, as it saps consumer’s purchasing power and squeezes producer’s profit margins. Alternatively, easing prices will give the central bank the ability to take a measured approach as it takes account of the continued decline in housing and slowing economy, reducing the chances of a rate increase. The lack of a threat of a possible rate hike may send the cable falling as traders will focus on the dour fundamentals.

Equities – FTSE 100 Index

The FTSE 100 index has been in a downward trend since it became clear that the BoE has ended its easing policy. As global leaders continue to warn of the secondary effects of rising inflation on consumers and manufacturers, the possibility of a rate hike has increased. The continuing deterioration of the housing market and the contracting service and manufacturing sectors will continue to weigh on stocks. The negative implications of rising producer prices are two fold. First it will increase the chances of a rate increase and it will continue to squeeze company’s profit margins. Falling prices will alleviate some of traders concerns and may help build on the recent support stocks have received from the oil and mining sectors.

Terri Belkas is a Currency Strategist at FXCM.