HIGHER INFLATION FORECAST BOOSTS STERLING

Disappointing production data hold it back. US inflation higher again at 3.2%.

It was another good week for the dollar, which led the field by a comfortable margin and rose by 1.2% against the pound. Sterling was looking quite good on Wednesday morning, up by more than a cent from Monday's starting point, but it quickly dropped back and extended its downward trend. The pound lost a net two cents on the week.

Sterling's mid-week rally happened courtesy of the Bank of England governor. Since the onset of the recession, Mervyn King has not been renowned for his robust promotion of sterling. It would be an exaggeration to say he has seized every opportunity to send it lower, but his pontifications have tended to offer more reasons to sell than to buy the pound. It was something of a surprise, then, when he hinted that sterling interest rates would indeed go up this year. His comments were in the context of the Bank's Quarterly Inflation Report. Although, as expected, the report marked down projections for economic growth, at the same time it marked higher the outlook for inflation.

The inflation report was the highlight of what was otherwise a week of dreary economic data from the UK. The Royal Institution of Chartered Surveyors house price balance improved from -23% to -21%, showing that prices are still falling, just not so quickly as before. Rightmove's whimsical house price index found would-be sellers asking an average of £239k for their palaces - a three-year high and 50% more than the £160k average transaction price reported by HBOS a week ago. Rightmove's press release suggests the mismatch could continue as long as interest rates remain near-zero: 'One interest rate rise won't immediately derail the market but if we see several in quick succession it will quickly hit the buffers.'

Although positive, the figures for UK manufacturing and industrial production in March were all on the low side of expectations. In February and March together, manufacturing production was up by just 0.2% and industrial production fell by -0.9%. Having already seen the provisional figure for first quarter gross domestic product (it grew by 0.5%), the production figures did not come as a shock. Indeed, they were not miles away from forecast. But they were not good and they held sterling back.

The week's US ecostats included the odd glitch but tended, on balance, to be positive for the dollar. The -$48 billion trade deficit in March was very similar to the predicted -$47bn shortfall, as was the 6.8% annual increase in factory gate prices and the 0.5% monthly increase in retail sales. The University of Michigan's consumer sentiment index was up by two and a half points to a provisional 72.4.

The April consumer price index data on Friday did the dollar no harm. Headline Consumer Price Index was up by 3.2% on the year with the core index, (excluding food and energy) up by 1.3%. Like the Bank of England, the Federal Reserve cares more about the underlying core rate of inflation than it does about the (presumably) temporary and transient effect of high oil prices. That 1.3% will not be cause for alarm. But the headline rate of inflation at the beginning of the year was 1.6%. It has doubled since then. Inflation is not high enough to trigger an interest rate increase today, but for how long will the Fed be able to ignore it if it carries on higher?

Most helpful to the dollar, though, were the market's misgivings about the eurozone debt problem, specifically the ongoing negotiations about Greek sovereign debt. When investors are unhappy enough to want to sell euros, their default replacement is either the US dollar, the Japanese yen or both of them. That’s what was going on last week. Less easy to understand is the way those same investors have apparently been able to disregard a different debt problem in Washington, where the government will run out of money tonight as it hits the $14.3 billion debt ceiling set by congress. It won't actually run out of money of course; congress and the administration will come to some sort of fudge rather more quickly than they did in the episode called ‘Shutdown’ in the fifth series of The West Wing. Nevertheless, America's rising indebtedness will return to haunt the dollar once the Greek problem has faded from the headlines.

There are no really meaty US ecostats due for release this week. The residential property market is covered by the NAHB index, existing home sales, housing starts and building permits. Industrial production, capacity utilisation and two regional Fed manufacturing indices cover industrial activity. The minutes of the Federal Open Market Committee will show that US rates will remain low for an extended period.

Four items on sterling's agenda are loaded with implication for sterling interest rates, and so for the currency itself. Analysts believe UK inflation will have gone up from 4.0% to 4.1% in April and that unemployment will have risen from 7.8% to 7.9%. Retail sales in April should be 2.5% up on the same month last year. The minutes of the May Monetary Policy Committee will reveal whether three of the nine members were still voting for a rate increase or if there has been some backpedalling as a result of softer economic data.

Sterling is now five and a half cents down from its early May peak and it could go further. Buyers of the dollar would be wise to use a forward purchase to fix a price for at least half the money they will need.

http://www.moneycorp.com

Helping you get more dollars for your pounds