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The Bank of England presents its third Inflation Report of the year at 1030 BST/ 0530 ET today. The Governor of the Bank of England will then take questions on the economic outlook from the press. Expectations are high that the Bank will reduce its inflation forecast for the next two years and also lower its growth forecast for the same reason. Back in May, the Bank forecast that inflation would be at 2.9% in Q4 before falling back to the target 2% rate by Q3 2013. However, inflation has fallen more sharply than the Bank envisaged and was 2.4% in June. Likewise, growth has also been disappointing; with the economy shrinking 0.7% in Q2, extending the UK's double dip recession. Back in May the Bank's central forecast was for growth to skirt along the bottom for the rest of this year.
There are two things to look out for later this morning: firstly, the inflation forecast. If the Bank suggests there is a higher risk of prices falling below the target 2% rate before Q3 of next year then that suggests that more monetary stimulus is likely in the near term, as maintaining stable inflation is the BOE's single mandate. The second thing is the Bank's growth forecast. The growth outlook remains extremely cloudy due to the impact of the extra Jubilee Bank Holiday and the Olympics. It will be interesting to see if the Bank thinks these are just temporary impacts on growth or if the recent weakness suggests a more ingrained downtrend in the UK economic outlook. Back in May the Bank categorised the economic outlook as "unusually uncertain", it will be interesting to see if it dampens its language further, reflecting deterioration in the Bank's expectations for growth in the coming quarters. If that happens then it would give a big hint that more asset purchases will be on the way.
So what could the Bank do?
1, Hint that it could cut interest rates (currently they are at 0.5%) in the coming months to boost inflation and consumer confidence. There is a high chance this may happen in our view.
2, Suggest that more asset purchases are on the way. Although the Bank may suggest it could do more QE if conditions deteriorate further, the Bank must see that QE is having a limited impact on the economy and Gilt yields are already at record lows.
3, Wait and see if the BOE/ Government Funding for Lending scheme that kicked off last month has an impact on growth. Bank lending tumbled 6.2% in June and weak Q2 results for some of the UK's biggest banks do not bode well for future lending. Thus, the Bank may decide to wait and see if the FOL scheme can boost growth before pledging further action. It could also put the onus on fiscal stimulus as a means to get the UK economy back on track. So the Bank may admit that it has run out of road and pass the baton to the government. There is a low probability that the Bank will call for more fiscal stimulus outright at this meeting, even if a VAT cut etc. is likely to be the most effective stimulant at this stage of the UK's economic cycle.
The BOE is likely to be dovish, even if it doesn't announce more stimuli, and it is likely that rates could move lower in the coming months, thus keeping more downward pressure on Gilt yields. The impact on sterling is likely to be determined by two things in the medium-term: 1, how much further can BOE action or rhetoric push Gilt yields even lower and 2, the outcome of the sovereign debt crisis as the pound has been used as a safe haven as the euro has been ditched.
UK Gilt yields (1.56%) have fallen below US Treasury yields (1.61%), which is a fairly rare occurrence and is fundamentally negative for GBPUSD. If the Bank suggests that it will cut interest rates in the near future then this could push Gilt yields even lower, which could weigh heavily on GBP versus the dollar and the Aussie in particular, which is likely to benefit from its yield advantage.
10-year UK Gilt and Treasury yields
Source: Forex.com and Bloomberg - please note Forex.com does not offer these products
GBPUSD is currently testing support at 1.5570 - the 50-day moving average and the base of the daily Ichimoku cloud. This is a significant support level since below here is the start of a technical downtrend. A dovish BOE could see us tumble towards 1.5500 to start with (the low from late July/ early August) and then 1.5480 - a key support zone.
EURGBP is a different type of beast. A dovish BOE could already be priced into this cross. It has staged a fairly good recovery since basing in mid-July. It is currently running into resistance at 0.7960 - the 50-day sma. While a dovish BOE may cause a bullish move towards 0.8000, it is already starting to look overbought on the daily RSI chart, and thus could be a sell on any strength emanating from the Inflation Report. Support lies at 0.7905 then at 0.7875 in the short term.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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