Currency traders received a surprise when UK inflation data was released on Tuesday July 18, 2017. Traders were caught unawares when June inflation figures were announced at 2.6%. Recall that the May inflation data was reported at 2.9%, prompting calls for an interest rate hike from economists and analysts. The surprising data for June (0.3% less) led to a sharp selloff of the GBP on currency markets.
A constant tug-of-war between the hawks and the doves in the Monetary Policy Committee (MPC) of the Bank of England may have tilted in favour of the doves with this recent economic announcement. In order for Bank of England Governor Mark Carney to justify a rate hike, inflation needs to be running rampant. A slowdown in inflation will bolster the case for a cautious approach to monetary tightening. As such, we can expect accommodative policies to continue for some time.
FTSE Traders Wrestle with Bulls & Bears
Typically, the FTSE 100 index – the UK all share index – rallies when the sterling falters. This is thanks to the inverse relationship between the two. Approximately two thirds of the companies on the FTSE 100 index generate their revenues from foreign-based operations. These income streams are denominated in currencies other than the GBP, such as the JPY, EUR, USD, CHF and SEK. When the GBP retreats against a basket of currencies, the foreign currency earnings are worth more in GBP terms.
The slight pullback from 1.31 (GBP/USD) towards 1.304 helped to mitigate losses felt on the FTSE 100 index. Unfortunately, the FTSE 100 was dragged into the mire by tobacco company share prices and plunging mining stocks. On the day, the FTSE 100 index closed at 7,390.22, down 0.19%, or 13.91 points.
Over the course of 1 year, the FTSE 100 index is up 10.38%, but it’s year to date return is just 3.46%. The 101-member index had 55 members down and 44 members up on July 18, 2017. Losses accrued with major companies like British American Tobacco (down 1.28%), Barclays PLC (down 1.91%), and credit ratings agency Experian PLC (down 2.05%).
The massive losses suffered by these heavyweights of the index outweighed the gains made by a weaker GBP. Part of the reason why BATS declined so sharply was the dual announcement by the British and Indian governments to curb tobacco smoking. Saxon Trade analyst, Charles Herman Sr., reported on the performance of the GBP and the FTSE 100:
‘…It appears that we have survived yet another potential calamity as UK markets were able to benefit from the weakness of the GBP and the FTSE 100 index. While trading activity on the currency is certainly bearish vis-à-vis consumer price inflation at 2.6%, the more pressing concern is how the Bank of England will react over the long-term
…. Speculators will short the pound if they believe that the prospect of further rate hikes is unlikely in 2017. This will help to mitigate losses suffered on the FTSE 100 index, as mining, airline and tobacco companies hit the skids. Plunging oil prices are driving down inflationary pressures, and provided this continues we can expect the BOE to hold back on additional quantitative tightening measures.’
Is the Rising Inflation Rate Related to Brexit Uncertainty?
Traders must be cautious not to draw spurious connections between the Brexit saga and everything negative that is reported in the media. However, the exodus of companies from the United Kingdom, and the fallout of political gobbledygook is having economic consequences for the UK economy.
For one thing, the GBP has hit a 32-year low against the greenback, despite a slight reversal above the critical 1.30 level. The volatility generated by the Brexit decision is having a contractionary effect on the UK economy. This is evident in the tightness in real wage growth, and the rising costs in the economy. Consumers are being squeezed from all sides, and this is evident in current GDP growth rates.
While the Bank of England may look towards net exports and business investment levels rather than inflationary pressures, it should not lose sight of the importance on consumption expenditure. The BOE has targeted an inflation rate of 2%, and that has been exceeded for several months in a row.
Over the short-term, there is no possibility of increased interest rates with lower inflation. However, this may be nothing more than a blip on the radar and inflation is likely to continue rising as import costs continue rising. Unfortunately, the political landscape is equally volatile with Prime Minister May desperately clinging to her position, and opposition MPs smelling blood in the water.