Talking Points:

All Eyes on the Bank of England Inflation Report in European Trade
Currency Markets Appear Primed for a Hawkish BOE Policy Posture
British Pound Likely to Drop as BOE Rate Hike Outlook Disappoints

The publication of the Bank of England Quarterly Inflation Report headlines the economic calendar in European hours. The document’s release has been the key inflection point for BOE monetary policy for some months now, with officials using the accompanying press conference as the primary venue to introduce pivotal changes in strategy.

February’s report carried a critical shift in the BOE’s approach to forward guidance. The Bank changed gears from an approach focused on reaching a 7 percent unemployment rate as the trigger to consider interest rate hikes to the more opaque notion of absorbing overall “spare capacity” in the economy before tightening.

The markets seem to view the BOE as relatively hawkish. Since mid-2013, the 2-year UK bond yield has steadily pushed higher alongside an orderly advance in 2014 GDP growth expectations (from a survey of economists polled by Bloomberg). Not surprisingly, the British Pound has followed suit. Today’s release may pour cold water on such rosy sentiments however.

February’s revision of the forward guidance regime was necessary because the jobless rate moved to the 7 percent threshold far faster than the BOE expected when that threshold was introduced in August 2013. To put it another way, the Bank saw fit to change its policy structure rather than follow through on improving economic news-flow.

That warns that officials are strongly predisposed against tightening, so much so that they would risk their credibility by explicitly abandoning a set of rules introduced mere months earlier. Against this backdrop, UK economic news-flow began to deteriorate relative to consensus forecasts at the onset of the second quarter. Most notably, the latest CPI data put the year-on-year inflation rate at a five-year low, speaking to ample spare capacity.

On balance, this opens the door for a far less hawkish tone to the Inflation Report than investors are positioned for. Needless to say, such an outcome is likely to bode ill for Sterling as yield-based support for the currency evaporates. We have entered short GBPJPY.

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