Sterling Strengthens as the Dollar Retreats, but Inflation Remains a Concern

Sterling Strengthens as the Dollar Retreats, but Inflation Remains a Concern

Last week saw some interesting movements across the major currency pairs, with GBP/EUR pushing towards 1.1850, while a reversal in the US Dollar helped GBP/USD recover towards 1.33 and EUR/USD move back above 1.12. Sterling’s performance against the Euro has been particularly encouraging, although as I have mentioned in recent weeks, much of that strength has come from the political and fiscal problems facing France rather than any significant improvement in the UK’s domestic outlook.

The Dollar’s recent performance has been more complicated. Falling US Treasury yields and reduced expectations of further Federal Reserve tightening initially helped the Pound and Euro recover some lost ground, although the latest US inflation figures have made the outlook less straightforward. September’s CPI came in at 3.7% year-on-year, while producer prices also rose considerably more than expected. This has brought the possibility of another rate increase back into the discussion, even if markets still consider a hold at the October meeting more likely.

I am not entirely convinced that the Fed needs to raise rates again immediately, particularly given the recent deterioration in employment growth, but inflation is clearly proving more persistent than policymakers would like. The recent Dollar weakness has provided another opportunity for those looking to purchase USD who may have missed the better levels a few weeks ago. How much further that move can continue is difficult to judge, especially with inflation remaining elevated and the next Fed meeting approaching.

Looking at the week ahead, Monday is relatively quiet, with little in the way of major economic data. Things become more interesting on Tuesday with the latest UK labour-market figures, including average earnings, employment change and unemployment. Wage growth is expected to ease, while the unemployment rate is forecast to remain close to 5%, suggesting that the labour market is continuing to lose some momentum.

This is becoming an increasingly difficult situation for the Bank of England. On one hand, weaker employment and slower wage growth would normally reduce the argument for higher interest rates. On the other, inflation remains above target and energy costs are continuing to put pressure on prices. A weaker-than-expected employment report could therefore weigh on Sterling, although I suspect markets will be reluctant to draw too many conclusions before Wednesday’s inflation figures.

We also have the latest ZEW Economic Sentiment surveys from Germany and the wider Eurozone on Tuesday. Expectations are for confidence to deteriorate, which would not be particularly surprising given the ongoing political uncertainty in France and the wider challenges facing European growth. The Euro has already come under considerable pressure over recent weeks, so another disappointing sentiment reading could reinforce that weakness.

Wednesday brings what I consider to be the most important UK release of the week, with September’s inflation figures. Headline CPI is expected to rise to around 3.4% year-on-year, while core inflation is forecast to increase to approximately 2.7%. These numbers will be closely watched ahead of the Bank of England’s next interest-rate decision, particularly given the growing debate around whether the Bank may need to raise rates again before the end of the year.

A hotter reading would clearly strengthen the argument for further tightening, although I don’t think the decision is quite as straightforward as simply responding to higher inflation. If Tuesday’s employment figures show further weakness, the Bank will have to weigh the risk of allowing inflation to remain elevated against the possibility of putting additional pressure on an already slowing economy.

Thursday is relatively quiet from a UK perspective, although we have the latest US weekly jobless-claims figures. Claims have remained relatively low despite weaker hiring, so I will be interested to see whether that continues. We also have UK public-sector borrowing figures, which are worth paying attention to with the Budget now less than a week away. Any further deterioration in the public finances would only add to the concerns surrounding the Chancellor’s ability to balance spending commitments against the fiscal rules.

Thursday is probably the busiest day of the week overall, beginning with UK retail sales. August’s figures showed a 0.5% monthly increase, following a decline in July, and September’s report will give us another indication of how well household spending is holding up. With inflation still elevated and the labour market showing signs of weakness, I think consumer spending is becoming increasingly important for assessing the underlying strength of the UK economy.

A stronger retail sales number would be encouraging for Sterling, particularly if the employment figures earlier in the week are disappointing. However, if spending begins to weaken alongside employment, it would add to concerns that the economy is losing momentum at a time when the Bank of England may still be considering higher interest rates.

We then have flash PMI figures from the Eurozone, UK and US, covering both manufacturing and services. These are useful because they provide an early indication of business activity during October, rather than looking back at conditions several months ago.

For the UK, the services reading will be particularly important given how heavily the economy relies on that sector. Businesses are dealing with higher energy costs, borrowing costs and continued uncertainty ahead of the Budget, so any indication that activity is slowing would be unwelcome. Manufacturing will also be worth watching, although I would place more weight on the services and composite readings when assessing the overall UK outlook.

The European PMI figures could be equally interesting. The ECB raised interest rates in September in response to renewed inflationary pressure, but economic growth across the Eurozone remains fairly subdued. If Friday’s figures show further weakness in business activity, it would highlight the difficulty facing the ECB as it attempts to control inflation without causing additional damage to the economy. Given the Euro’s recent weakness, another disappointing set of figures could provide further support for GBP/EUR.

In the US, the PMI releases should help us understand whether businesses are continuing to expand despite higher interest rates and inflation. Recent US data has painted a mixed picture, with employment growth slowing while inflation remains stubbornly high. If business activity continues to hold up, the Fed may feel more comfortable maintaining restrictive monetary policy. A weaker reading, particularly in services, would make the argument for further rate increases more difficult.

Finally, we have the University of Michigan’s consumer sentiment figures later on Thursday. I will be paying particular attention to the inflation-expectations component, as this can tell us whether households believe the recent increase in prices is temporary or something likely to persist. With energy costs having risen considerably, there is a risk that consumers begin expecting higher inflation for longer, which is exactly the sort of development the Fed will want to avoid.

Overall, I think this week should give us a much clearer picture of the challenges facing the Bank of England ahead of its next meeting. We have employment, inflation and retail sales all within a few days, and it is entirely possible that they point in different directions.

For Sterling, however, I still think the Budget on 28 October remains the biggest domestic risk over the next couple of weeks. My view hasn’t changed significantly: I wouldn’t be surprised to see some weakness as we approach the announcement, particularly if concerns around borrowing and taxation continue to build. Equally, I still think there is scope for the Pound to recover afterwards if the Budget is credible and avoids any major surprises.

GBP/EUR approaching 1.1850 is certainly a welcome development for Euro buyers, while the recovery in GBP/USD has provided another opportunity for those needing Dollars. I would be cautious about assuming either move continues indefinitely, though, particularly with the UK Budget and another Federal Reserve decision both approaching before the end of the month.

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