Relative inflation is driving GBPUSD higher
Relative Inflation
Source: www.tradingview.com
The above chart is a relative strength chart of the UK inflation rate against the US inflation rate year-on-year. In effect, we divided UK inflation by US inflation. The result is quite striking. The trendline's gradient has shifted upwards from the green to the orange to the red trendline. This indicates that UK inflation is outpacing US inflation at a greater rate over time. One of the key reasons for this is that the Federal Reserve has a greater control over US inflation than the Bank of England has over UK inflation.
Yesterday's inflation print out of the US showed further moderation in June. We are still waiting for a comparative data point for UK inflation, but the US CPI surprised to the downside. Headline CPI y/y came in at 3%, marginally lower than the expected number of 3.1% and a full percentage point down from May's 4%.
Relative Inflation Felt in Fixed Income and Forex Markets
Source: www.tradingview.com
Given that the relative inflation is trending up, it is no surprise to see the spread between the UK 2-year gilt and US 2-year note also moving in a northeasterly direction (top chart). Both the Federal Reserve and Bank of England are aggressively fighting inflation via their respective monetary policies.
The 2-year instrument is a good proxy for monetary policy because the short-end of the yield curve responds quickly to changes in the costs of capital. The spread moving upwards and to the right suggests that the BoE is currently regarded by the fixed income market as being more aggressive than the Fed in its inflation battle.
The middle chart shows the GBPUSD forex pair. Given that the spread is moving higher, it is not surprising that cable is also moving upwards. In fact, the bottom indicator is the correlation coefficient between the spread and GBPUSD. It is a robust 92%.
Daily Overbought Condition
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GBPUSD's daily RSI is overbought (blue rectangle). This does suggest a pullback from current levels will by appropriate as the oscillator normalises.
However, on a longer-term basis, and given the strong correlation coefficient above, as long as the relative inflation remains skewed to the UK side, we think GBPUSD is likely to be supported due to the BoE's efforts to control prices.
Russell Shor
Senior Market Specialist
Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.
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