UK's June Inflation

The Office for National Statistics (ONS) had another surprise for the markets on Tuesday, this time it was the Consumer Price Index (CPI), which grew by 1.9 percent in the year to June 2014, up from 1.5 percent in May. The latest June CPI, an official measurement of inflation, is now hovering close to the Bank of England’s (BOEs) annual inflation rate target of 2.0 percent, so all bets are now on an imminent interest rate rise in the UK. Indeed, the market’s reaction to the surprising jump in June’s CPI figures was predictable; there was a flight of hot money into sterling in search of a higher return, thereby pushing the exchange value of the UK pound further against the USD to a session high of $1.7133. The UK pound also appreciated against a basket of other currencies. Moreover, the price of UK bonds fell sharply on the bond market as traders fled UK bonds in anticipation of a rate rise before the end of the year. So markets have now priced in an interest rate increase, from a record low, to 0.5% interest base rate by the end of the year. 

The latest June CPI figure, released by the ONS on July 15, confirmed that British inflation has now surged to a five month high last month. The main reason behind the sharp rise in the May to June inflation rate has been price increases in food & non-alcoholic drinks; however, the figure is now little changed on the year to June. A variety of product groups notably fresh vegetables, bread and cereals, contributed to the monthly inflation rise in foods. Also the price increases in clothing, particularly women blouses and shoes, also added to the rise in June’s inflation figures. The relatively good weather throughout the May-June period could have resulted in retailers deterring price discounts as the sector decided to cash in on the cloth shopping spree, brought about by the fine weather. Air transport also registered a big month to month hike in prices, according to the ONS. Air fares rose between May and June 2014. The movements were primarily driven by changes in fares on European routes, according to the ONS report. The ONO June CPI report also added, that prices in the housing, water, electricity, gas & other fuels sector continue to have the largest upward effect on inflation, which have contributed around a quarter of the total June CPI figure. Alternatively, motor fuels currently have a downward pull on inflation. Average petrol prices were around £1.30 in June this year compared with £1.34 a year earlier.

But the June CPI figure of 1.9 percent did come as a bit of a surprise for the market. A recent poll conducted by Reuters indicated that economist had forecasted a small rise of inflation to just 1.6 percent. However, the question puzzling economist is whether the June CPI figure is just a monthly blip or further evidence of the UK’s upward trajectory for inflation this year, which would also mark the end of Britain’s historic period of low interest rates. "It currently looks a very close call as to whether the Bank of England will raise interest rates at the end of this year or hold off until early-2015. Indeed, there will undoubtedly be many swings in interest rate expectations over the coming weeks and months," said Howard Archer, economist at IHS Global Insight.

Indeed, the common belief that economists can’t agree on anything important is probably more than ever relevant to them forecasting the UK inflation rate and interest rates. One school of thought is that the June CPI figure is merely noise and that reading too much into a monthly set of figures is really a distraction when trying to forecast the UK inflation trajectory. This reasoning may hold water, after all clothing and air fare prices are usually volatile and one month’s inflation data alone cannot completely change the overall trend. Adding support to this view was an official from the ONS who said that there were signs that the good weather last month may have deterred retailers from cutting prices. Elizabeth Martins, an economist with HSBC, also added that the clothing effect was likely to be smoothed out in July's data. 

Moreover, the recent data shows that producer costs continued to fall last month and that there was barely any rise in what they charged customers in the so-called "factory gate prices". There’s also unlikely to be any wage type inflation, as the latest figures on pay are widely expected to show wage rises continuing to lag well behind inflation, in other words falling in real terms. Furthermore, the steady appreciation in sterling since the beginning of the year will be lowering the price of imports, thereby exerting downward pressure on inflation. "In the near-term, inflation is likely to remain subdued with the producer price inflation figures highlighting a lack of pipeline price pressures while remarkably low wage rate numbers also point to little near-term inflation threat. The strength of sterling will also help limit the upside for inflation," said James Knightley, economist at ING Financial Markets.

But not all economists see it that way. Referring to June’s CPI data, Chris Williamson, chief economist at data specialists Markit said, "The news will further fuel expectations that the Bank of England will start raising interest rates sooner rather than later, with November looking the most likely month for the first hike," said Chris Williamson, chief economist at data specialists Markit. Apparently, Markit’s survey is showing activity picking up.

However, if housing prices cool down in the months ahead, then probably the CPI June figures are just a temporary blip on the radar, meaning that future inflation rates could be within the BOE inflation target of 2 percent and therefore, no interest rate hikes in 2014 would materialize. The likely fall in real wages, the appreciating pound, the spare capacity in the economy and the frail euro zone recovery may put a damper on future inflation figures. So maybe the market has jumped the gun in anticipating pending interest rate rises.

Interest Rates in the UK

Interest rates are a tool that central banks use to implement monetary policy. They represent the percentage rate at which interest is paid by a borrower for the privilege of using money that has been lent to them and the interest can be paid at various time intervals. Higher interest rates will have an impact upon inflation and employment and could lead to a reduction in consumer spending and investment. The Bank of England meets every month to set the UK bank rate. There are nine members of the Committee and they are appraised of all the latest data on the economy and business conditions. Their task is to keep inflation below 2% but above 1% in the following 2 years.

In the UK the current rate of interest, also known as the base rate, as set by the Bank of England, is 0.5%. This is an historically low level which has been in place for the past 5 years in order to aid the country's recovery from the recession brought about by the financial crisis. It is anticipated that interest rates will have to rise sooner rather than later, although there is much speculation about the date of the first rate rise which is anticipated to be in the first half of next year. The new normal level for rates is expected to be 2 to 3%, well below the 5% from the late 1990s to the financial crisis. In 1976 interest rates hit 15% and double digit interest rates were not uncommon between 1975 and 1991.

Mark Carney, the governor of the Bank of England, and Charlie Bean, the outgoing Deputy, have both indicated that rates will peak at around 3% in 3 to 5 years time, below the pre-crisis average of 5%. There have been indications that rates may start to rise in the next 12 months and in the latest minutes of the Bank of England's meeting it seemed that a decision was now more finely balanced than in recent years. It is essential that the Bank of England raises rates slowly so that it does not choke off the recovery that is beginning to come through. Britain's economy is growing faster than any of the other Group of Seven countries at an annual rate of 3% and it is not clear what impact an interest rate rise would have on the economy after the long recession.

Charlie Bean has suggested that any rises are in "baby steps" in order to avoid making mistakes. In other words he thinks the Bank should be cautious - this could entail raising rates soon - but at a smaller rate than has been implemented in the past, for instance at a rate of increase of 0.1% instead of the previous normal rate of 0.25%.

It is generally accepted that low interest rates are inflationary and the Bank will be watching for early signs that this is happening and try to move interest rates up early to forestall it. Generally they would raise interest rates if they were concerned that inflation was on the increase in order to reduce demand and slow the rate of economic growth. At the present time there are no signs that inflation is picking up with the latest CPI figure coming in at 1.8% which may be attributable to the output gap.

Interest rate movements have the largest impact for individuals on savings, mortgages and annuities, whilst for businesses it impacts the level of demand, interest on loans and the present value of assets and liabilities.

Over the last 5 years savers have been badly hit by the low level of interest rates. This has been particularly hard for pensioners with savings. Higher interest rates would make it more attractive to save cash in deposit accounts as the level of interest received would be higher than at present, thus reducing the need to take on extra risk to earn a decent reward.

At the same time interest payments on credit cards and loans would increase making them more expensive to use and would act as a disincentive. Those who have existing loans may find them harder to finance due to higher interest payments and this could reduce their spending in other areas.

In Britain there have been concerns about the housing market recovery and the possibility of a bubble forming, particularly in London. The Bank of England will be more concerned about the risks of a large increase in debt than about price growth due to a lack of supply. If interest rates rise mortgage payments linked to the variable rate will also rise and new mortgages will also be issued at a higher rate. This would also have the impact of a brake on spending as disposable income would be reduced. For instance a 0.5% rise in interest rates would increase the payments on a £100,000 mortgage by £60 a month.

Annuity rates have been very low during the financial crisis as they are linked to interest rates via the 15 year gilt or government bond yield. When interest rates rise annuity rates should also improve. Those retiring in the coming years should be able to secure a higher income. A half a percentage rise in interest rates could see yields on the 15 year gilts rise by 50 basis points which could result in a 5% rise in annuity rates whilst if interest rates reach 1.75% annuity rates could be 12.5% higher.

The value of sterling would increase if interest rates rose. International investors would be more likely to use British banks for their savings if the interest rates in the UK are higher than in other countries.

A strong pound also makes British exports less competitive which could have the effect of reducing exports and increasing imports thus reducing the overall demand in the economy.

Interest rate rises also have the general effect of reducing confidence both for the consumer and business which has the effect of discouraging risk taking and investment.

Predicting when rates are likely to increase is difficult. One indicator that may help to predict when interest rates are likely to rise are the overnight swap rates which often influence the market rates of fixed mortgages and fixed rate savings bonds.

Darren Winters

Currency Markets for week beginning 19 May 2014

To kick off the week let's take a look at the Euro dollar and Sterling dollar currency pairings, and take a view on where they may be going. Let's start with the Euro - EUR/USD.

The weekly chart below shows a clear uptrend dating back to around August 2013. For a currency that was deemed to be in crisis 18 months ago, the Euro is holding up better than expected over the longer timeframe.

EUR/USD Weekly chart

If we drop to a daily chart the picture is more range bound, we've been going sideways since March. There was a sharp dip on May 8 when Mario Draghi, the president of the European Central Bank, suggested that monetary policy might be loosened to stop prices falling, and also to combat low inflation. The euro has continued to fall since then - an overall 200 points from 1.39 to 1.37. The general consensus seems to be that the currency is a little too strong at the moment, which weakens exports and has inflation way below the level Mr. Draghi would like it to be at 0.7%. The target figure is just below 2%.

EUR/USD Daily Chart

There is a rough support level at around 1.3670, (see the continuous blue line above), which was tested last Thursday, but only temporarily breached before bouncing back. That breach on May 15 was down to lower than anticipated Eurozone economic data. The region grew 0.2% as opposed to the expected 0.4%. This gives even more credence to the possibility of the ECB acting in June to adjust monetary policy, which could see a further fall. From an intraday trading perspective the 4 hour and 1 hour charts are also range bound, but the 15 minute chart is showing some momentum.

What's on the economic calendar for the Euro this week?

Tomorrow (Tuesday 20th) we'll get data for the producer price index early in the day. The industrial sales index figures come out two hours later, at 9am.

Then on Wednesday current account data for transactions in and out of the Eurozone is released at 8am. A high positive figure should be a bullish signal, though this is not flagged as a high impact event.

On Thursday we'll see a Business climate report at 7.45am, showing the current state of French business conditions. At 8.30am the German Purchasing Managers Index report comes out, followed at 9am by the same PMI data for the Eurozone as a whole.

On Friday you'll see some GDP and business climate data from Germany, with Retail Sales, wage inflation and trade balance data from Italy. And also remember that the elections for the European parliament are happening this week.

None of the economic indicators above are seen as big ticket events, but nonetheless, it's worth keeping an eye out to see what impact they have. The outlook for the Euro going into June though looks decidedly bearish, especially if Mr. Draghi acts on the hints he's so far given us.

Moving on to Sterling now - GBP/USD

The weekly chart shows a strong uptrend for Cable, perhaps that should be no surprise as the UK is touted as the fastest growing economy in Europe this year. Yes, it dropped a bit last week, but is showing signs of a revival today.

GBP/USD weekly chart

 

If you're a purely technical trader this is an uptrend to die for on the weekly timeframe. And it's quite well reflected at the daily level, below. There's a support level around 1.6750, which has been tested and bounced off.

GBP/USD daily chart

 

If you drop down to the lower timeframes it's been a bit range bound, but with a slight spike up early this afternoon. But there's quite a lot coming up for Sterling on the economic calendar this week, and they're events that could trigger some significant movement.

Tomorrow sees the Consumer Price Index being released at 9.30am. This is basically an indicator of inflation and purchasing trends, and could have a market impact. At the same time we'll see Producer Price Index and Retail Price Index reports.

On Wednesday it hots up even more, with the official Bank of England decision on what will happen to interest rates being released. I would expect rates to remain unchanged, but if that's not the case watch out!

Then on Thursday at 9.30am we have GDP data coming out, another potential high impact event. Although the UK is experiencing recovery, and employment figures are looking better, productivity hasn't been rising at a proportionate rate. So this could be significant data.

It's a quiet day for Sterling on Friday. Again, we have the European elections this week, and if UKIP does well the markets will no doubt react, which way of course is another question. But right now the outlook for sterling looks bullish.  

The longer term outlook suggests that if support holds at around 1.6660 (next level of support below the one I've drawn above), that Sterling will continue to be bullish. With economic growth forecast at around 3.8% this year and continuing into 2015, the rising momentum could take us to around 1.73, though some opinion sees the market as overbought, which tempers this estimate.

Darren Winters 19/05/14