GBP/JPY extends recovery as hot CPI boosts BoE hike odds

It has been a great week for the pound, particularly for the GBP/JPY pair which has been supported by a double dose of bullish factors this week.

• UK CPI jumps unexpectedly – BoE now highly likely to raise rates by 25 bps
• Improving market sentiment reduces appeal of yen
• GBP/JPY could be heading to 165

Why has GBP/JPY been rising?

The pound found support across the board as the GBP/USD hit its best level since early February after an unexpected acceleration in UK CPI to 10.4% has cemented expectations over a 25-basis point BoE rate hike on Thursday. Oher pound crosses rose across the board, including the GBP/JPY, which broke above

Meanwhile, the Japanese yen has also started to sell-off again, as major government bond yields have bounced back with an improving risk appetite. Market sentiment improved sharply at the start of this week as financial markets calmed down following the coordinated central bank support and UBS's takeover of Credit Suisse.

Traders have been buying the pound across the board in recent times, as they perceive the UK banking sector to be better insulated from the banking crisis.

Before today’s inflation report, the Bank of England’s interest rate decision on Thursday was coin flip between a 25-basis hike or no change in monetary policy. But knowing that the BoE has the option to use targeted measures to address financial stability risks – like it did during the mini-budget crisis of last year – and can use more traditional measures – i.e., changing the Bank Rate – to continue its fight against inflation, we were already leaning towards a rate hike. That’s because of inflation, which, as we found out earlier this morning, showed no signs of abating.

UK inflation jumps unexpectedly

While there have been signs suggesting inflation might have peaked, this was not reflected in the latest inflation report released this morning. The BoE will have to wait longer for evidence to emerge that CPI will be heading towards their 2% target in the no-too-distant future.

Ahead of the release of UK CPI, analysts had expected a modest drop in the headline annual rate from the 10.1% recoded in January, to 9.9%. Core CPI was seen falling to 5.7% from 5.8%. However, both measures came in much higher with headline CPI rising to 10.4% and core CPI to 6.2%.

What to expect from the BoE?

The recent turmoil in financial markets means the doves among the BoE’s rate-setters will be more inclined to vote for a no change and will also point to the fact that the impact of past hikes is yet to filter through to the economy. They will argue that the cost of hiking too much may outweigh any benefits additional tightening might achieve. The likes of Silvana Tenreyro and Swati Dhingra will undoubtedly push for a no-change.

However, the centrists and the more hawkish members of the MPC will point to the still-very high inflation rate in the UK. This camp will want to avoid a premature pause in the hiking cycle so as to ensure inflation has a good chance to return to target quicker. They will also argue that price action in Gilts have been comparably more stable than US Treasuries and German Bunds, and a lot less volatile than during the mini-budget debacle last year. This is because the market perceives the UK to be better insulated to banking problems seen in Europe and the US.

This therefore implies that the split among the BoE’s monetary policy committee members may widen further. However, the BoE had already set a much lower bar for pausing its rate hikes, compared to the likes of the ECB and Fed. So, if it decides against a rate hike because of financial stability concerns, this will not come as a major shock to the market – for as long as it leaves the door open to hike in one of the upcoming policy meetings if inflation does not come down sharply enough.

All told, I do think that the BoE will go ahead with a 25-bps hike at this meeting and then pause to assess the impact of the previous hikes. As we saw around the time of the mini-budget crisis last year, the BoE separated its inflation fight from the financial stability risks, by temporarily purchasing bonds while simultaneously hiking interest rates. With the BoE joining several other central banks in announcing a coordinated action to enhance the provision of liquidity this weekend, there is no need to announce any bond buying again. So, it can go ahead with a rate hike to try and tame inflationary pressures.

How will the pound react to the BoE’s decision?

A 25-basis point rate hike is now mostly priced in, especially in light of the latest inflation data and the corresponding positive reaction in the pound. However, it is not just the rate decision that will impact the pound. The split of the votes will count, as too will the language the BoE uses in terms of forward guidance. In general, the more hawkish the UK central bank is, the more gains should be expected for the pound, and vice versa. But if the BoE makes it clear that it will pause its hiking then this should keep the upside limited for the pound.

All told, the GBP/JPY could be heading towards 165.00, for as long as the bulls now manage to defend support around 162.00 - 162.20 area, the base of today’s breakout.

-- Written by Fawad Razaqzada, Market Analyst

Follow Fawad on Twitter @Trader_F_R