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UK inflation update could rattle markets

Image shows a close-up of a pile of £1 coins.

The UK faces another scorching and potentially market-moving consumer price index (CPI) reading on Wednesday. Estimates suggest that headline CPI rose 10.7% in the year to October, up from 10.1% in September. Meanwhile, core CPI is forecast to have increased 6.4%, easing slightly from September's level of 6.5%. 

On a month-on-month basis, headline CPI for October is expected to have climbed 1.7%, up from September’s increase of 0.5%. 

CPI announcements have become binary events for global markets, as cooler-than-expected data lead to significant short-covering equity market rallies, like the one witnessed in the US this past week. In contrast, a hotter-than-expected reading may lead to currency strengthening, higher rates, and falling equities.

If UK inflation in October exceeded 10.7%, rates could rise further. The two-year gilt yield, currently around 3.1%, has fallen sharply since ex-chancellor Kwasi Kwarteng’s so-called mini-budget sent rates soaring. Markets have calmed since Jeremy Hunt took over as chancellor, and yields have returned to their September levels. 

However, the September 2023 overnight swap now sees the Bank of England raising the overnight rate to 4.54%, down from 4.9% ahead of the Bank’s meeting on 3 November. That has resulted in the spread between the overnight swap rate and the two-year gilt rate narrowing further to 1.42% from 1.64% two weeks ago. Nonetheless, that spread over time should continue to contract, especially if the UK’s central bank intends to push interest rates higher, as the market expects. 

Are gilt yields set to rise?

Despite falling sharply, the two-year gilt has remained inside its downward-sloping trading channel, as shown in the chart below, and the bull flag remains in place. Additionally, bullish developments suggest that the two-year rate may be getting ready to move higher. The two-year bottomed on 3 November and started to edge higher. Meanwhile, the relative strength index has also increased, suggesting that momentum may gradually shift from bearish to bullish. 

However, should the CPI report miss expectations, it is likely to reduce the peak overnight terminal rate that the market is pricing in. This reduction could cause the two-year to fall back to 2.85%. 

The pound could gain versus the dollar

If rates rise, the pound could continue to climb as it attempts to break out versus the dollar. Sterling could rise above resistance around $1.17 and push above a downtrend that started in November 2021, potentially moving up to $1.21. 

The relative strength index has also been increasing, making a series of higher highs since May, indicating that momentum is directionally bullish for the pound. However, if rates do not rise, the pound could slip versus the dollar and potentially test support at $1.17, possibly falling back to $1.13. 

The FTSE may be putting in a short-term top

The FTSE 100 has risen significantly over the past two weeks. To maintain that upward momentum, it needs rates to fall. But a further advance looks limited at this point, with apparent overhead resistance at a downtrend that started in April, which comes just below 7,500. 

Additionally, the relative strength index is flashing overbought signs after reaching the 70 level twice since 4 November but failing to push higher despite the equity index making a higher high. This could be the first sign of a bearish divergence forming and a signal that the rally may be approaching a short-term top. A pullback could result in the index falling back to a range of 6,950 to 7,140.

The UK CPI reading for October, due early on 16 November, is likely to be a market-moving event and a winner-takes-all data point. There may be little room for error if the numbers come in hotter or cooler than expected. But it is important to remember that, over the long term, a minor beat or miss on the headline number is unlikely to transform the Bank of England’s monetary policy. Whatever happens, the UK’s battle against inflation seems far from over.

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