Fundamental Forecast for British Pound: Bearish

The British pound has been somewhat of an anomaly among the major currencies since the beginning of the month. While the majority of its counterparts fell in with broad-based trends in investors' risk appetite, the UK unit remained uniquely focused on domestic matters, with traders most concerned about how the Bank of England will resolve the conflicting objectives of capping the sharp surge in inflation while keeping the fragile economy from slipping back into recession. Needless to say, the central bank has proven willing to remain accommodative despite uncomfortably high CPI growth rates, opting to make growth the policy priority. The economic data set due for release in the week ahead promises to reinforce the status quo, putting the Pound on the defensive.

Central banks look past month-to-month volatility in the inflation rate, targeting an overall rate over the medium term, which typically implies a one- to two-year time horizon. With that in mind, they are most concerned with inflation expectations rather than the absolute level of prices at a given time. Indeed, if people begin to expect prices to grow in the future, they will demand higher wages, the cost of which will be passed on to companies’ customers and become not only a self-fulfilling prophecy but a notoriously difficult to break vicious cycle. On balance, this means that elevated prices do not become a serious problem even if they persist for some time as long as they do not structurally alter expectations and thereby endanger medium price stability.

From this perspective, the Bank of England has been right to keep rates on hold. Indeed, price growth expectations for the next five years – derived by comparing the yields on regular and inflation-indexed UK government bonds of equal maturity – have been trending lower over the past two months and are now poised to break the uptrend in place since August of last year. This has been mirrored in a dramatic decline in the priced-in rate hike outlook, with a Credit Suisse gauge tracking investors’ bets on tightening for the coming year down 56.9 basis points from their April peak to finish last week at the lowest level since early January.

The May edition of Purchasing Manager Index figures headlines the calendar in the week ahead, with expectations calling for a dour set of figures. Service- and manufacturing-sector growth are expected to slow for the second and fourth month respectively, while the Construction industry registers a shallow uptick having slowed the most in nine months in April. Second-tier indicators promise to be little more encouraging, with Mortgage Approvals down and the Halifax House Price report showing real estate values shrank at a faster pace. On balance, this points to further downward pressure on BOE rate hike bets, keeping a firm lid on the Pound against its leading counterparts.

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