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The Bank of England stole the headlines this morning as it delivered its second Inflation Report of the year. Its message was fairly grim: the UK won't regain its 2007 level of output until 2018. The biggest threat to the UK economy right now according to the bank is the impasse in the Eurozone (something the BOE can't control).
The BOE: blame the Royal Family and the Eurozone
However, the one thing it can control is QE and interest rates, and it kept the door to more QE firmly open today. It noted that Q1 GDP figures could be revised higher, however a number of one off factors like the Queen's Jubilee bank holiday this year could knock 0.5% from GDP. This holiday could have a more damaging economic effect than the Royal Wedding, according to the Bank. While the Bank held back from blaming the Royal Family for the UK's economic malaise, it did say that the outcome on the UK economy of a disorderly break-up of the Eurozone is extremely difficult to predict and thus it excluded these scenarios from its forecast.
Inflation to remain more persistent than originally forecast
However, the Bank did note that the strength of the economy will depend on a gentle increase in consumption and households' real incomes gaining traction. For household spending to increase it may take a fall in price pressure. However, this is where the Bank delivered the bad news: it said that inflation was likely to stay higher for longer than it expected three months ago, and it could remain above the 2% target for the next year or so. However, in the long-term it still sees inflation dropping sharply. Since the Bank sets policy with a two-year time frame, at this stage higher near-term inflation is unlikely to stop the Bank from doing more QE. The sharp drop in commodity prices in the last two months may dampen global inflationary pressure going forward, so if we were to see price pressure decline more quickly in the coming months than the Bank currently expects then we could see more QE especially if events in the Eurozone continue to remain critical.
Sterling was the most volatile mover in the G10 so far today. GBPUSD finally gave up its resistance and fell below 1.60 at the London open. It had held up better than the other G10 dollar crosses like USDCAD, AUDUSD and EURUSD, however once it went through 1.60 it always looked vulnerable. Next the market focused on the Inflation Report and the Bank's focus on prices and the weak growth outlook (which it took to mean more QE). Investors ignored the better than expected UK employment data and continued to sell sterling even though the number of people claiming jobless benefits dropped by 13.7k in April, after the unemployment rate dropped to 8.2% in March. 1.5900 was breached at one stage, although GBPUSD then looked grossly oversold on a short-term basis. We have since recovered to 1.5920, and could make another stab at 1.5950, ahead of 21-hour sma resistance at 1.5970. The BOE put the focus back on the Eurozone worries as a major risk to the UK economy, thus it is hard to see how GBPUSD break back above 1.60 when the situation in the currency bloc remains so grave.
Risk has been in recovery mode today after the markets reacted to the news that Greece was definitely heading back to the polls. It always seemed likely that Athens would need another election although it's hard for the country to justify the EU 18mn price tag when it is scheduled to run out of money in July, according to the Greek officials. After dipping below 1.27, the dollar bulls took a breather and we saw a nice recovery in EURUSD back to 1.2730. This is a normal pullback for the cross. The bears still appear to have control of the markets right now and EURUSD may test the 1.2624 January lows in the coming days. The strength of the dollar (the safe haven of choice right now) is eroding some major levels in G10 currencies. 1.2624 in EURUSD looks vulnerable, 1.60 in GBPUSD, USDCAD is back above parity and AUDUSD may breach the 0.99 level.
Yesterday we noted that FX markets were not yet in panic mode. That all changed after Greece announced it was going back to the polls. EURUSD volatility spiked up to a 5-month high. In the past, higher volatility has been associated with central bank action to alleviate adverse situations. If volatility continues to remain elevated then it may force the ECB to take more remedial action to support Europe's banks, which are particularly vulnerable to a sovereign collapse.
The commodity space has clawed back some recent losses; however, it still looks weak. The CRY index fell to its lowest level since 2010 yesterday and gold is close to testing long-term 100-week support at $1,522 per ounce. This is a major level in the yellow metal, and is likely to be respected by the market, so expect some stickiness between $1,530 and $1,550. But if the Eurozone crisis continues to cause heightened market uncertainty we believe a breach of the 100-week sma is possible.
Watch US housing data and Fed minutes today. I don't expect the minutes to have much effect on the markets, although the last round of minutes were dollar positive, and any hint of hawkishness from the Fed is likely to be jumped on by the greenback bulls.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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