GBP fails to sustain gains after strong UK CPI

NZD falls sharply as RBNZ signals top in rates

EUR slightly softer after mild IFO decline

UK April CPI was way above market consensus, with headline at 8.7% against 8.2% expected, and core CPIH hitting the highest since 1992 at 6.2%. GBP initially ganed, but fell back to opening levels. It may be that we are reaching the limit to the extent to which a currency can benefit from higher inflation.

While headline CPI inflation fell to 8.7% y/y in April from 10.2% y/y in March, this was a much smaller decline than expected, with the consensus having been for a decline to 8.2%. The BoE had forecast a fall to 8.4% in the May Monetary Policy Report. Core CPIH, one measure of core inflation, rose to 6.2% y/y, the highest since 1992. EUR/GBP looks vulnerable as short term rate spreads were already suggesting downside risks before the numbers, and there could be scope as far as 0.86, or even to the December lows below 0.8550. 

Of course, there is always the question of how long higher inflation is likely to be seen as a positive factor for the currency. In emerging markets, it generally isn’t, but in this latest inflationary episode in the major markets, the increase in nominal rates driven by higher inflation has far outweighed the direct valuation impact of higher inflation or any longer term concerns about the negative effect of monetary tightening. But there will come a point where higher short term rates mean lower long term rates as markets price a bigger recession risk as a result of the monetary tightening, and recession fears outweigh any positive impact from higher rates in the short run. However, the UK is not there yet, with economic forecasts turning more positive in recent weeks, with the IMF for instance no longer forecasting a UK recession. We are less sure of this, as the current monetary tightening has led to a sharp contraction in money and credit, and things could yet deteriorate quickly. But for now we expect GBP to make more gains across the board, despite the initial reversal of gains. 

Ahead of the UK data we had the RBNZ rate decision. 21 out of 25 forecasters expected a 25bp hike, but the market was priced for a 25bp and a 50bp move being equally probable. However, although RBNZ raised rates to 5.5% as expected it also signalled a peak in rates. RBNZ hints that the rate would be here to stay until inflation returns to target band, which on the current forecast would take 2 years. They are forecasting continual moderation of headline inflation but core inflation would be stickier for the moment. Labor market has also shown signs of peaking with shortage easing and vacancies declining. The signal of peak rates sunk the Kiwi by more than 1.5% against the USD.

TheGerman IFO survey showed a modest decline in the business climate index, due to a decline in the expectations component. The softer number ges against the improving trend seen in the last few months, and may indicate that the impact of monetary tightening is strating to be felt in earnest. EUR edged a little lower, but the impact has so far been modest, and for now we would expect EUR/USD to hold in the high 1.07s.