It’s all about inflation and interest rates

14 October, 2014

Tom Arnold

Since it hit the 6 year highs against the Euro that we saw following the Scottish referendum, the Pound has really not been performing all that well. A selection of mixed data has provided little support, but in the face of talk of a return for the Eurozone to recession, you might have expected the Pound to make hay and push up past those recent highs. 

There are two real reasons for this somewhat surprising failure to perform. Firstly the talk of the Eurozone going back into recession itself – as we have seen in the last few years a recession shackled Eurozone weighs heavily on the UK economy because the EU is after all our largest marketplace, and secondly the Bank of England and interest rates.

There is a fairly serious balancing act going on for the Pound that hinges on when the Bank of England are going to raise interest rates. Higher interest rates mean a higher yield for investors and hence a stronger currency, and expectations have ebbed and flowed over the last year about when the rises will start. The current consensus is Spring 2015. This is without a doubt heavily priced into the current Sterling position, i.e. the market is already realising a lot of the strength these rises will bring. What this means is that if there is any indication that UK interest rates might not rise in Spring 2015 then the Pound could be in some trouble as this “pricing in” unravels.

Today sees one of the major factors in when interest rate rises will come announced in the form of UK CPI inflation. Inflation and interest rates are intrinsically tied together as interest rate changes are the method of control that the Bank of England uses over inflation. Higher than wanted inflation can be subdued with interest rate rises and lower than desired inflation can be stimulated by interest rate cuts. The problem at the moment is we have record low interest rates and lower than target inflation, which equals no real need for the Bank to do anything, hence the balancing act for the Pound… Does the bank need to raise rates in Spring 2015 if inflation stays low?

The answer will become clearer as we see the next few months worth of inflation figures, starting today. We are expecting a drop in inflation today, which already means we are probably expecting a drop in Sterling – some analysts are anticipating an even lower figure though, which could mean the start of the Sterling decline.

In other news the Eurozone is struggling as discussed earlier and a key indicator of German economic sentiment is due out in the form of the ZEW survey today – last week we saw some poor figures for the German economy, and this time last month the ZEW survey was significantly down – a repeat is likely to cause Euro weakness.

Make sure you stay in close contact with your CI account manager to be kept informed of exactly what is happening in exchange rate news and how it is likely to affect your upcoming currency purchase.