FTSE 100 on a roll as CPI is weaker than expected

The pound may be in the doldrums after the surprise drop in the CPI rate for July, but the FTSE is still riding its recent wave higher. It broke above its 50 and 100-day sma earlier and continues to extend gains as we move towards the UK lunchtime.

The decline in annual CPI to 1.6% from 1.9% was mostly down to a decline in clothing prices, as summer sales hit the high street. However, weakness in the CPI rate was fairly broad-based with large downward effects from alcohol, financial services and food. The largest upward effect came from transport costs, however this was probably seasonal due to the school summer holidays falling in July.

This is the lowest rate of CPI since May; however, prices could stay subdued for some time after weakness in producer prices for last month. Input prices fell by 7.3%, to the lowest level since 2009. Producer prices can be a lead indicator for CPI prices, so weakness at this stage of the inflation pipeline could keep CPI below the BOE’s 2% target for some time.

Lower inflation can be good news for the FTSE in a couple of ways:

• Firstly, it makes it less likely that the MPC will raise rates in the near term, and a benign interest rate outlook can be good for stocks.

• Secondly, falling energy prices along with falling wages helps boost corporate profits.

Although the inflation data is positive for the UK index, the fundamental picture is not clear cut. If tomorrow’s BOE minutes show one or more MPC members voted for a rate hike earlier this month then we could see a reversal in the pound, higher UK bond yields and weakness in the FTSE.

So how do you manage these risks?

Since there is a large event risk on the horizon for Wednesday (BOE minutes) some investors are taking profit after some stellar gains in the FTSE in recent days. This is normal as the market waits for the risk to pass before assessing where the FTSE may go next.

Positive outcome:

If the BOE minutes confirm that the interest rate environment remains benign then we could see the rally in the FTSE continue. Key resistance levels to watch out for include: 6,850- - the high from late July, above here opens the way to 6,894 – the May high and the highest level since 1999.

Negative outcome:

Even though momentum seems to be to the upside, the BOE has flip-flopped between being dovish one day and neutral-to-hawkish the next, so we can’t count on the market’s perception of the UK rate environment remaining stable. If there was a dissenter at last month’s BOE meeting, the first one since 2011, then we could see weakness in the FTSE. So be prepared for a volatile ride in the next 24 hours. Key support lies at 6,754 – the 61.8% retracement of the May – August decline. Below here opens the way to 6,705 – the 200-day sma.

Takeaway:

• Weakness in the UK’s July inflation reading has boosted the FTSE on Tuesday.

• Falling prices could mean that rates won’t rise until prices start to stabilise.

• Lower inflation combined with weak wage growth helps to boost corporations’ bottom line, which can be good news for stock prices.

• However, Wednesday’s BOE minutes are still a risk. If we get a split vote at the MPC with some voting for a rate hike then we could see the interest rate environment shift, which could weaken the FTSE.

• In the lead up to this event risk there could be some profit-taking in the FTSE.

• Familiarise yourself with key support and resistance levels ahead of the BOE minutes.