The Pound Remains Sterling

Softer than expected UK inflation is threatening to halt sterling's advancing streak to five sessions. Consumer prices slipped 0.1% in May, while the consensus expected an increase of 0.1-0.2%. The year-over-year rate of 1.5% represents a four year low.

The market responded in the expected way, pushing short-sterling interest rate futures higher and sterling lower. However, after the knee-jerk reaction, the markets stabilized, sustaining only modest moves. Sterling bulls were already a bit vulnerable after the push through $1.70 yesterday was not sustained. Sterling slipped about half a cent, but held last Friday's low/Thursday's high ($1.6920-30) and quickly rebounded to session highs.

Sentiment remains constructive, but now cautious ahead of the MPC minutes out tomorrow. Based on Carney's comments, the market had begun pricing in a hike for early 2015. Such expectations have eased slightly on the softer CPI figures. Going out through 2016, the short-sterling futures have returned to little change levels.

The real debate at the BOE is over the extent of economic slack. The decline in prices now does not seem to reflect such macro conditions. Instead, for example, downward pressure on prices came from the supermarket price competition. Food and (non-alcoholic) beverage prices are off 0.6% over the past year, the first year-over-year decline in 8 years and the largest decline in nearly a decade. Transport prices fell as fare increases over Easter were unwound.

That said, there does not appear to be price pressures in the pipeline. Input prices fell 5% year-over-year. The consensus was for a 4.1% decline. Output prices fell l 0.1% in May and are up 0.5% from a year ago. On the other hand, the government separately reported that house prices increased by 9.9% in April, the strongest level in 4 years. In London, house prices rose 18.7%.

The idea that tame inflation will boost consumption may not be borne out in the retail sales data due out on Thursday. The consensus expects a correction to the heady 1.3% rise in April, with around a third given back in May.

For its part, for the fifth session, the euro remains in a roughly $1.3510-$1.3580 range. In thin Asian activity, it briefly popped through the cap and rose to just shy of $1.3588. Within this narrow range, initial support is seen in the $1.3540-50 area. Technical factors favor a test on the downside in North America.

Separately, for the first time the ECB's decision not to sterilize the SMP purchases comes into force. However, the 7-day repo operation resulted in a net drain of nearly 39 bln euros. Other economic news has been largely limited to the German ZEW survey that shows the continued pattern of sentiment in the sense the current assessments are constructive, while the expectation component deteriorates, as if the average respondent is saying now is the best things gets.

The ZEW's measure of the current situation rose to 67.7 from 62.1 in May. This is well above expectations (62.1) and is a three-year high, perhaps aided by the record highs in the DAX. The expectations component, which the consensus had expected to improve fell to 29.8 from 33.1. This is the lowest reading since December 2012.

The Australian dollar is the weakest of the major currencies. It lost about 0.5% against US dollar in response to the RBA minutes, which opened the door to a possible rate cut in the future. Many participants have been flirting with the idea of the hike next year. The issue is whether interest rates are sufficiently low to facilitate a transition away from mining investment as the key driver.

The RBA also referenced the Australian dollar in terms of weaker commodity prices. We note that iron ore prices continue to fall and have now fallen below $90 a tonne for the first time since September 2012. China's inventories are reportedly high and the major driver. The Australian dollar has been very resilient in the face of the decline in iron ore prices and other commodities.

This is not exactly the enigma that some suggest. Sure Australia exports commodities, but capital flows are, arguably more important. It is still among the highest interest rates among AAA credits and has an increased role as a reserve currency. Simply put, the foreign exchange price that brings the trade account into equilibrium is not the same that brings the capital account into equilibrium.

The Australian dollar put in a low near $0.9340. It is likely to consolidate near-term, with potential back toward $0.9370-80. However, the failure to hold above $0.9400 for the third time in three months, may weigh on the late longs. In the futures market, for example, the gross longs have more than doubled since the end of March and at 62k contracts, is the largest in a year. 

The North American session features May CPI, and housing starts figures. The former remains tame and the latter disappointing. The bigger focus is on the 2-day FOMC meeting that gets underway. Look for our preview later today.