What Are The Markets Facing?

Currently, the markets are betting that the Bank of England will raise the Bank Rate by 25 basis points to 5.25 percent by the end of the year. Given the rapid acceleration in inflation and Mr. King’s forecasts that CPI would rocket above 4 percent, the market’s judgments seem reasonable. However, it was Mr. King’s letter to the Chancellor just a few weeks ago that suggests the Bank of England may, in fact, leave rates steady. Unlike the European Central Bank, which raised interest rates in early July, the BOE has a dual mandate to maintain price stability and to promote sustainable growth and employment. The UK has already seen indications of a broad economic slowdown, but adding the fragile nature of the UK’s financial sector to the mix puts the Bank of England in a particularly precarious position, as a rate increase meant to fight inflation could easily push the UK into recession and trigger a severe credit crisis. As a result, the UK's MPC will likely continue to sound hawkish on inflation in order to contain consumer inflation expectations, but when it comes down to it, their bark may be bigger than their bite, as the Bank of England is highly unlikely to actually raise rates during the third quarter.

Bonds – Long Gilt Futures

Gilts have made a steady recovery from the June lows, though the contract has recently run into resistance at 106.50. Furthermore, the upcoming rate decision by the Bank of England could weigh Gilts down toward support at 105.45. While the BoE is widely expected to leave rates steady, economic data out of UK has recently proven to be extremely disappointing, which has helped send Gilts higher. However, the decision to leave rates unchanged would signal that inflation is currently their predominant concern.

FX – GBP/USD

In recent weeks, the GBP/USD has moved within the 1.96-2.00 range, and remains range-bound as the Bank of England maintains a hawkish outlook on inflation but cautious stance on the economic downturn. Indeed, current economic conditions have greatly deteriorated in recent months, which is likely to lead the Bank of England to hold the Bank Rate at 5.00% tomorrow. However, as Governor Mervyn King forecasts inflation to rise above 4 percent in the near future, market participants are expecting the central bank to anchor inflation expectations, and may leave the door open for a potential rate hike later in the year. From a technical perspective, the 50 and 200 SMAs have thus far kept GBP/USD within an even tighter range, and a decision to leave rates unchanged could allow the pair to rise toward to the top of the range once again.

Equities – FTSE 100

Bearish sentiment and risk aversion has dragged global equity indices lower during the past few weeks, but many have stabilized in recent days, including the FTSE 100. Looking ahead to Thursday, the FTSE 100 faces event risk from the Bank of England’s rate decision. Market participants expect the BoE to hold a neutral policy stance as the economy is faced with rising inflation amid a slowdown in economic activity, which may lift the FTSE 100 to break through near-term trendline resistance to target 5,625. On the other hand, the release of an unexpected policy statement along with the decision to leave rates steady could lead the FTSE 100 down toward support at 5,400, especially if the statement signals a hawkish bias amongst many members of the Monetary Policy Committee.

Terri Belkas is a Currency Strategist at FXCM.