The gyrations on currency markets on Tuesday again underlined the importance of interest rate expectations for currency traders.
Much worse than expected inflation figures in the UK drove higher the expectations of UK interest rates. Investors in futures markets in the world’s fifth largest economy now expect rates to move up to 5.75 per cent by the autumn from their current rate of 5.25 per cent.
By contrast, weaker than expected inflation figures in the US reduced the chances of another rise from the Federal Reserve, giving traders cause to sell the greenback.
There is little that is inevitable about currencies moving in line with expected interest rates and nothing in long-term trends that allows people to predict currency movements in connection with inflation and other variables. But on Tuesday, the currencies moved exactly as if they were linked to the inflation figures by an umbilical cord.
At 9:30am in London, UK inflation was revealed to be 3.1 per cent, the highest annual rate of change since 1992. The pound immediately surged through the $2 level for the first time since it was ejected from the European exchange rate mechanism on “Black Wednesday” in September 1992.
The concern for the Bank of England, which has authority to set interest rates, was twofold. First, the level of inflation, more than one percentage point higher than its target of 2 per cent, triggered the first letter of explanation from Mervyn King, the governor, to Gordon Brown, the chancellor. This letter is an integral part of the monetary policy framework but the fact it had never been sent before Tuesday risked raising the general awareness of high inflation in the UK. Officials stressed the normality of the letters in the monetary policy process; but the letter also suggested there was a risk that inflation expectations could go higher.
Second, the detail of the figures was worrying in that the Bank could not point to exceptional reasons for the rise. Higher prices were broadly based and could be seen in the mean, the median and in the distribution of price changes.
Mr King acknowledged in his letter that “businesses have become more confident that they could raise prices to rebuild profit margins”.
Richard Jeffrey, an economist at Ingenious Media, saw the trend towards rising prices as a return to normality after a period where Britain was more-or-less alone in experiencing sharply falling goods prices on the high street alongside normal levels of overall inflation.
Interest rate expectations jumped and a May rate rise is now considered a certainty. “People have to get used to higher interest rates than we have seen for much of this decade. I am not sure that house-buyers are taking that into account yet,” said Martin Weale of the British National Institute of Economics and Social Research.
Sterling and other European currencies jumped again at 1:30pm London time as milder than expected US inflation figures were published. Sterling broke through $2 for the afternoon, the dollar hit a new two-year low against the euro and also fell against other leading currencies.
The official data released on Tuesday showed a slowdown in core inflation – as prices excluding volatile food and energy costs rose by 0.1 per cent last month after a gain of 0.2 per cent in February.
Alan Ruskin, a currency strategist at RBS, said: “What we are seeing is those investors chasing risk moving to higher yielding currencies. These numbers reinforce an existing trend.
“There had been persistent fears about inflation boxing in the Fed and making it difficult to respond to a slowdown in growth. Now the Fed is less boxed in.”
The Fed still views inflation as a slightly greater threat to the US economy than the uncertain outlook for growth but investors sold dollars on the basis that the inflation slowdown made the Fed more likely to keep interest rates on hold and could give the central bank slightly greater flexibility to consider easing monetary policy in future.
US government debt prices rallied as investors priced in a lower likelihood of US rate cuts, sending the yield on the benchmark 10-year note down to 4.71 per cent from 4.74 per cent.
London experienced the opposite trends in bond markets, again contrasting the current accelerating economic expansion in Europe with the slowing US economy.
