FxWirePro: UK inflation beats consensus, if not Cable’s spot trade, excitement in EUR/GBP vol trades

Consumer prices in the United Kingdom rose by 3.1 pct in the year to November 2017, following a 3 pct gain in the previous month and beating market expectations of 3 pct. It was the highest inflation rate since March 2012, mainly due to rising prices of transport, leisure activities, restaurants and hotels, housing and food.

The upside surprise would likely lead to the release of an open letter to the Chancellor alongside Thursday’s BoE interest rate decision.

As the impact of sterling’s depreciation on prices appears to have peaked, we expect a gradual easing in the pace of CPI inflation through next year. However, inflation is forecast to stay above the 2% target through both 2018 and 2019. Against that backdrop a key question for the Bank of England will be what is happening to domestic inflationary pressures and tomorrow’s labour market report will provide a further update on these. If not in short run, sterling seems to be sensitive particularly to idiosyncratic and to the whims and fancies of Brexit headlines in the medium run.

Although the end result of the past two weeks of drama around the EU-UK divorce bill has ended up with a reported breakthrough in the negotiations, we note this is but one of many hurdles in the overall Brexit negotiation process, which will increasingly dominate GBP in 2018 as we head closer to the cliff-date of March 2019.

Depending on how the negotiation process evolves, with lackluster IVs in ATM contracts across all tenors and spiking IVs of 3m EURGBP ATM contracts (refer above IV nutshell), GBPUSD risk scenarios ranging from 1.26 to 1.47, and rather than a directional conviction in the spot, our favored GBP trade is to be long EURGBP vol.