Sterling fundamentals will take centre-stage on Wednesday with high volatility inevitable. The Bank of England inflation report will have a mixed tone and plenty of caveats, especially as Governor Carney will want to keep as much flexibility as possible. While not ruling out a 2014 rate increase, he will again insist that policy is data dependent. Sterling bulls and bears should both be able to find some comfort in the report with the threat of several shifts in direction. The overall tone is likely to be slightly less convincing surrounding the economy and sentiment will already be damaged if there is a negative reading for headline average earnings amid the threat of further underlying profit taking. The best approach looks to be fading any initial headline Sterling spike higher against the dollar. Alternatively, run a limited short Sterling position ahead of the unemployment release with wide stops.

Over the first half of 2014, Sterling pushed strongly higher as short-term funds moved aggressively into the currency with stronger growth fuelling expectations of Bank of England tightening. The mood has turned more cautious over the past few weeks with doubts over the sustainability of growth and greater doubts over the interest-rate path. After prepping markets in June for a possible 2014 interest rate increase, Governor Carney failed to follow-through on his hawkish rhetoric.

The fundamental reports due on Wednesday will be extremely important for sentiment and Sterling. Markets are not fully pricing in a 0.25% rate increase until March 2015 so there is certainly scope for sharp short-term Sterling gains if there are strong hints over a 2014 rate increase.

First up for release will be the latest labour-market data. Markets have almost become immune to strong clamant-count data with declines of over 20,00 every month since July 2013. The unemployment rate is likely to have ticked lower to 6.4% from 6.5%, in theory pushing the economy closer to full employment which could push the Bank of England nearer to tightening. The earnings data will be watched extremely closely and is likely to be the most important element given that the Bank of England is very uncertain how much spare capacity is still available in the economy. A slow rate of earnings growth would suggest that there is still considerable spare capacity even with falling unemployment. Significantly, the consensus forecast is for earnings to fall 0.1% in the year to June which would be an important negative Sterling factor. Concerns over very weak productivity would be a key long-term bearish Sterling influence.

One hour after the labour-market data the latest Bank of England inflation report will be released. This provides the bank’s economic forecasts and is the backdrop for yield expectations. The report will be extremely important as the central bank will want to provide the theoretical underpinning and justification for any monetary tightening. With the next report due for release in November, failure to signal a rate hike this month would substantially undermine the possibility of an increase this year.

These are several key factors to watch in the inflation report:

1.  The bank will estimate how much spare capacity is still available in the economy. Previously, the estimate was 1-1.5% of GDP. Any increase in this estimate to say 1.5-2.0% would effectively rule out and interest rate increase for 2014, while a reduction in this estimate would make an increase this year much more likely.

2.  The inflation forecasts will obviously be important as they are the bank’s central focus. A projected rate below 2% in two-years time would lessen the risk of an early tightening.

3.  Comments on Sterling will need to be watched closely. The bank expects Sterling strength over the first half of 2014 to dampen inflation. Markets will need to watch carefully whether there are warnings over potential damage to the economy from an over-valued currency and any attempt to talk it down. Any warnings over balance of payments vulnerability will also be important.

4.  International growth forecasts will be important with the bank likely to be more wary over the Euro-zone outlook and wider global trends which will also make it cautious over any early tightening.

5.  Governor Carney’s press conference will need to be watched very closely as the media probes for more decisive rhetoric on interest rates and there is the scope for high volatility during the press conference as well as on the inflation report headlines.

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http://www.investica.co.uk/marketreport13-08-14.htm

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