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Trading News Report

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U.K. Producer Price Index at Hand, Can the British Pound Hold Its Ground?

Mon, Nov 10 2008, 07:06 GMT
by Daily FX Research Team

DailyFX

Inflationary concerns for the U.K. are expected to dissipate as economists forecast the producer price index to fall to 7.4% from 8.5% in September. The significant slowdown in the domestic economy paired with falling commodity prices have certainly helped to ease price pressures for Europe’s second largest economy, and would allow the Bank of England to remain focused on growth as the economy heads into a recession.

Trading the News: U.K. Producer Price Index Output

What’s Expected

Time of release: 11/10/2008 09:30 GMT, 04:30 EST

Primary Pair Impact : GBPUSD

Expected: 7.4%

Previous: 8.5%

Impact the U.K. PPI Output has had on GBPUSD after the last 3 releases

September 2008 U.K. Producer Price Index Output

Factory-gate prices in the U.K. dropped for the second consecutive month in September as economic activity weakened throughout the second half of the year. The producer price index slipped to 8.5% from a revised reading of 9.1% in August on the back of falling commodity prices, and should allow the Bank of England to lower borrowing costs further as the economy heads into a recession. The MPC voted unanimously cut the benchmark interest rate by 50bp in a coordinated effort to restore confidence in the financial market, and lowered the rate to 4.50% from 5.00%. Easing price pressures paired with fears of a significant economic downturn has already stoked expectations that the BoE will continue to cut borrowing costs in the near-term, which could weigh on the British pound going forward.

August 2008 U.K. Producer Price Index Output

U.K. producer prices unexpectedly declined for the first time in nearly a year due to a significant pullback in commodity prices. The PPI slipped to 9.7% from 10.2% in the previous month, which suggests that inflation may have peaked during July.
Easing prices pressures will certainly allow the Bank of England to shift their focus to growth and push inflationary concerns to the backburner, which leaves the door open for a potential rate over the coming months as growth prospects for the U.K. deteriorate. Meanwhile, the MPC continued to hold a neutral policy stance as they voted to hold the interest rate at 5.00% during the September 4th meeting, while Chancellor Alistair Darling explicitly stated that Great Britain may face the worst economic downturn since the 1940’s.

July 2008 U.K. Producer Price Index Output

Wholesale prices in the U.K. rose at its fastest pace since recordkeeping began in 1986 as firms continue to face higher food and energy costs. The producer price index jumped to 10.2% from 10.0% in June, which crossed the wires slightly weaker than the 10.3% estimate projected by economists.
Mounting price pressures have become a growing concern for the Bank of England as Governor Mervyn King expects the inflation rate to remain well above the central bank’s limit of 3%, which could lead the MPC to hold a neutral policy stance for the remainder of the year despite the downturn in the economy. Falling home prices paired with the ongoing weakness in the credit market has certainly taken a toll on Europe’s second largest economy, and the U.K. may face a recession during the second half of the year as growth prospects deteriorate.

How To Trade This Event Risk

Inflationary concerns for the U.K. are expected to dissipate as economists forecast the producer price index to fall to 7.4% from 8.5% in September. The significant slowdown in the domestic economy paired with falling commodity prices have certainly helped to ease price pressures for Europe’s second largest economy, and would allow the Bank of England to remain focused on growth as the economy heads into a recession. The downturn in the housing market paired with the spillover effects of the credit crunch has clearly become a growing concern for policy makers, and has led the BoE to push inflationary concerns to the backburner as a result. Meanwhile, the MPC surprised the markets yesterday by lowering the benchmark interest rate by 150bp to 3.00% from 4.50% despite expectations for a 50bp cut, and is widely expected to ease policy further over the coming months as fears of a global recession intensify. The central bank decided to lower borrowing costs to the lowest level since 1955 as they stated that upside risks for inflation have ‘shifted decisively to the downside,’ and went on to say that they expect credit conditions ‘to remain restricted’ in the near-term. Moreover, the bank explicitly stated that the considerable reduction in the interest rate was essential ‘to meet the 2 percent target’ for inflation, which suggests that prices pressures could be falling at a faster rate than the initial forecast held by the central bank. The extraordinary efforts by the BoE indicates that the economy is slowing at a record pace, and conditions may only get worse as the Euro-Zone, the U.K.’s biggest trading partner, teeters on the brink of a recession. Meanwhile, Credit Suisse overnight index swaps are showing that market participants anticipate the BoE to lower borrowing costs by at least 200bp over the next 12 months, which could stoke increased selling pressures for the British pound over the following months.

Despite the dovish outlook held by the MPC, a stronger than expected reading for wholesale prices could stoke increased buying pressures for the British pound as headline inflation remains well above the central bank’s 3% limit. The consumer price index surged to 5.2% from 4.7% in August, followed by a 0.2% increase in the core inflation rate, and a PPI reading of 8.0% or higher will favor a bullish trade for the Sterling. As a result, we will look for a green, five-minute candle following the release to confirm entry on two lots of GBPUSD, and we will place our initial stop at the nearby swing low (or reasonable distance). This risk will determine our first target, and our second target will be based purely on our discretion. Once the first lot reaches its target, we will move the stop on the second lot to breakeven in order to preserve our profits.

However, as the Bank of England drops their hawkish tone and turns their attention to the downside risks for growth, easing price pressures could stoke bearish sentiment for the British pound. Therefore, a PPI reading below 8.0% would clearly favor a short GBPUSD trade, and we will follow the same setup for the short position as the long trade listed above, just in reverse.

Published on  Mon, Nov 10 2008, 07:16 GMT