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Now that the dust has settled regarding yesterday's Bank of England Inflation Report a couple of things to note regarding the price action:

1, Although the pound sold off fairly sharply, it still remains strong relative to the other G10 currencies. GBPUSD is still in a technical uptrend above 1.6000, currently it is trading at 1.6140 after some hawkish comments from Andrew Sentance.

2, Although UK gilts and short-sterling futures (interest rate futures) rose after King's speech, yields didn't fall too far. Although they have come off their tops they remain at elevated levels.

Overall, the market is still pricing in 2 rate hikes by the end of the year.

So, what has this done to the relative outlook for UK yields how does this alter the picture for the GBP crosses?

 

The analysis below looks at the GBP crosses and interest rate differentials - the green line is the cross, while the white line is the spread between UK 2-year rates and other G10 countries.

GBPUSD: Two year yield differential between UK and US yields (white line) has come off from its highs at the start of this month. But yields still remain elevated, which should support cable above 1.6000. The spread is currently at 0.65, if it falls below 0.60 then that would be bearish for sterling and we could see GBPUSD back toward the 1.5800 January lows.

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EURGBP: The spread has also come off its highs, but not as sharply as the UK-US spread, suggesting that the pound has a bit more fuel versus the euro than it does versus the dollar. EURGBP has bounced off 0.8400 support and could see some more strength. But if interest rate expectations don't rise in the Eurozone, then we could see the spread start to drift higher weighing on EURGBP.

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GBPCHF: Overall, the spread is in GBP's favour as investors have reduced their expectations for further rate hikes from the Swiss Central Bank. This has helped GBPCHF to rise nearly 10 big figures since the start of the year. Although yields have come off their highs, the direction of GBPCHF is still higher.

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GBPJPY: Again, the yield differential is very much in GBP's favour. This is fuelling GBPJPY strength. However, the as the spread has come off its highs in recent days this hasn't been followed by a moderation in GBPJPY, which supports further gains in this cross after a period of consolidation.

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GBPAUD: The spread has started to narrow after reaching a low back in November 2010. But the yield differential kicked in as a driver of GBPAUD with a lag of one month and we didn't see GBPAUD reach a low until the start of this year. Currently the spread is in a range, which could cap GBPAUD gains at 1.6200 for now.

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GBPCAD:  The spread has come off extremely sharply as the Canadian economic outlook has picked up. Although GBPCAD is stuck in a range, the spread hasn't fuelled a GBP decline. Thus, something else is driving GBPCAD. We believe that GBPUSD is driving GBPCAD, due to the close relationship between the US and Canadian economies, and GBPCAD will continue to take its cue from the cable rate for now.

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GBPNZD: An unusual price action. The spread has moved sharply in GBP's favour since the start of the year in line with the deterioration in the outlook for the Kiwi economy and the reduction in rate hike expectations from the RBNZ. The low in the spread corresponded with the low in GBPNZD. Although the spread has come off fairly sharply, the consolidation in GBPNZD has been more muted. Overall, the spread is still supportive of GBPNZD, but if we don't see the spread continue to narrow, the GBPNZD gains could be capped below 2.15.

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Conclusion: The market is still pricing in for the Bank of England to be the first of the major central bank to hike interest rates, which will continue to fuel GBP gains.

Yield are still supportive of the uptrend in GBPCHF, GBPJPY and GBPNZD. While yields suggest that although GBPUSD, EURGBP will remain in technical up-trends they are range-bound for now. Yield differentials suggest that GBPAUD and GBPCAD are still in their ranges and remain at risk from a reversal if markets perceive any pick up in hawkish rhetoric from Australia and Canadian central banks.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7398 5024 | f: +44.(0).20.7929.2010 | e: kbrooks@forex.com| w: www.forex.com/uk

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