Another UK CPI upside surprise points to possible 50bp hike by BoE.

GBP: Growth concerns will temper pound gains.

The recently released May CPI report in the UK brings more bad news, as the month-on-month (MoM) gain in CPI is 0.7%, surpassing the expected 0.4% increase. Consequently, the annual rate remains unchanged at 8.7% instead of the anticipated decline to 8.4%. What's even worse is that underlying inflation pressures are the cause of this unexpected surge, with the core CPI year-on-year (YoY) rate reaching a new cyclical high of 7.1%, up from 6.8%. In contrast, other advanced economies have started to observe slower underlying inflation YoY growth rates. This is a concerning outcome, as the Bank of England (BoE) had predicted a YoY gain of 8.22% for Q2 2023 in its May forecasts. Unless there is a significant downside surprise in the June data, it appears that the Q2 YoY inflation rate will be notably higher than expected.

Taking a closer look at the details, Clothing & Footwear experienced a substantial 1.3% MoM increase, while Household expenses rose by 1.1% MoM. Communications saw a 0.9% gain, Recreation 0.7%, and Restaurant & Hotels increased by 1.0%. There is some positive news regarding food and non-alcoholic beverages, as their inflation rate slowed from 19.1% to 18.4%, aligning with other data sources suggesting that food inflation has peaked. However, services inflation accelerated once again from 6.9% to 7.4%, which is a significant and alarming increase at this stage of tightening, raising concerns for the BoE.

Considering the BoE's Q2 2023 forecast of 8.22% and the consecutive readings of 8.7%, my calculations indicate that the MoM inflation rate would need to decrease slightly for the BoE to achieve its Q2 target. In response to this data, the OIS market showed a pricing of approximately 30 basis points (bps) for tightening today. Now, that figure has jumped to 37 bps, and it is possible that it may increase further throughout the day.

The BoE will likely be reluctant to revert to a faster pace of tightening, as it may appear panicky and suggest a loss of control over inflation. Unfortunately, to some extent, this is the reality. The BoE might lean towards caution and opt for a 25 bps increase, arguing that the lag effects will soon start to demonstrate a clearer impact. Encouragingly, yesterday’s Producer Price Index (PPI) data revealed stronger evidence of disinflation, with the PPI Output YoY rate decreasing from 5.4% to 2.9% due to significant MoM declines.

Initially, my prediction for today was a 25 bps increase, but given this alarming inflation report, I’m slightly more inclined towards a 50 bps increase. While more aggressive action could provide a short-term boost to GBP, concerns among investors regarding the implications for economic growth will likely restrict the extent of appreciation at higher levels. As a result, GBP/USD may approach the 1.3000-level. However, we are currently treading a fine line between high inflation/BoE policy action strengthening GBP and high inflation/perceived BoE policy mismanagement undermining the pound.

UK CORE CPI OUT ON ITS OWN AS NEW CUCLICAL HIGH REACHED

Source: Bloomberg & Macrobond

USD: Powell semi-annual to throw light on FOMC message.The 2-year UST note yield has risen by approximately 30bps this month, largely in anticipation of a hawkish tilt from the FOMC meeting held last Wednesday. Since the meeting, the 2-year yield has not seen further advancements but has maintained its gains, which is likely viewed as a successful outcome by the FOMC.

The FOMC aims to uphold tight financial conditions and is therefore adopting a tough stance, signaling two additional rate increases for this year through the dots profile. Market reactions have reflected the removal of previous expectations for easing this year, although the market has only priced in a hesitant outlook for further rate hikes—less than one 25bp hike is priced. Yesterday, Fed Chair Powell delivered his semi-annual testimony to Congress. Given its proximity to the FOMC press conference, it may be challenging for Powell to convey a different message. However, nuances and tone carry significant weight, allowing Powell some scope to modify expectations if he wishes. Nevertheless, like last week, it will be arduous to explain the rationale for pausing while also justifying the intention to implement two more rate hikes.

As I mentioned last week, a pause should be seen as a signal of increased contentment with the inflation outlook. While the semi-annual testimony may align broadly with the FOMC press conference statement in terms of message and tone, the Q&A session could be more crucial than usual today, as members of the House Financial Services Committee are likely to question Powell regarding the conflict between pausing and signaling future hikes.

The general expectation is for Powell to emphasize a "higher for longer" approach, but it is difficult to envision this message resonating significantly differently with the markets compared to last week, which can be summarized as "skeptical acceptance." The true determinant of whether the FOMC will hike again or not will be the incoming data between now and the July meeting.

With only one NFP and CPI report before the July meeting, I cannot confidently state that the FOMC will refrain from hiking. However, by September, we will likely have a much clearer indication that the FOMC has concluded its hiking cycle. The US economy is not as robust as portrayed by FOMC members, and this should become apparent by that time. In the meantime, aside from minor fluctuations in the US dollar and rates, the markets will likely await key data points to gauge the Fed's actions, such as the PCE inflation report next week, followed by the ISM and NFP reports the following week, and the CPI report the week after.

FED RATE CUT EXPECTATIONS IN 2024 HAS HELPED WEAKEN THE DOLLAR

Source: Macrobond

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