UK inflation debate hots up boosting the pound
ZEW further undermines the EUR. BoC this afternoon.

Sterling again stole the limelight this morning with stronger than expected inflation data providing investors with an additional reason to favour the pound. News that Cadbury has agreed a deal with Kraft had earlier provided some positive sterling news and ongoing concerns over the impact on EMU from Greece's budget problems remains a prime support. CPI rose a stronger than 2.9% y/y in Dec well above the Bank of England's 2.0% target. This is prompting speculation that the BoE may be forced to bring forward the first rate hike of the cycle. This, however, is far from being a done deal. Energy prices remain a main driver of the rise in CPI. Base effect surrounding last year's temporary reduction in VAT is also impacting. Insofar as both of these effects are likely to be temporary, inflation is likely to fall back to far more moderate levels in a few months time. That said, there is a danger that the higher headline inflation levels will impact wage deals. Also, underlying inflation failed to fall back as much as the BoE had predicted last year despite the lengthy recession, so the next few months will be fairly nail biting. Cable saw highs of 1.6454 this morning, EUR/GBP continues to trend lower in reflection of the pressure on the EUR. The break below trendline support in the GBP0.8740 area further weakens the outlook for the EUR. BoE Governor King is due to speak tonight, any remarks on inflation could be key.

Germany's January ZEW survey provided more negative news for the EUR this morning. This was weaker than expected at 47.2. It follows recent indications from Germany's statistical agency that the pace of the recovery in Germany moderated significantly in Q4. Greece continues to contribute most of the negative pressure on the EUR. After last night's meeting of Eurozone Finance Minsters Commissioner Almunia described Greece's budget plans as adequate but noted some ambitious targets. Market scepticism on the outlook for Greece is unlikely to ease until some improvement in the budget is noted.

EUR/AUD today pushed to an 8 year low as the AUD continues to find support on speculation that the RBA will hike rates again in February. Against the USD, the Aussie is consolidating with its momentum sapped slightly by fear that Chinese authorities will continue to tighten. The yen has been better bid vs the USD on fear that further tightening by the PBOC will lead to reduce risk appetite. This morning, however, USD buyers emerged below the USD/JPY 90.40 area. Comments from the PBOC that it will stick to a moderately loose monetary policy this year and it see only a small increase in CPI should help calm fears about asset price bubbles in China.

This afternoon the BoC is expected to keep policy unchanged at 0.25%. The BoC has maintained that it will not be altering policy until the summer. Any more hawkish indication from the BoC could be instrumental in pushing USD/CAD back to its recent low at 1.0220 and potentially below.

The continuation of US earnings season, US TIC flows, housing and consumer confidence data will be of interest in addition to the BoC policy meeting.
Jane Foley
Research Director