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How does inflation impact currency pairs, like the USD/GBP?

Analysts share their thoughts with Yahoo Finance on how currency pairs are impacted by inflation changes

George Washington and Winston Churchill USD/GBP
USD/GBP: The British pound against the US dollar is one of the most frequently traded foreign exchange pairs. Photo: Getty (John Lamb via Getty Images)

Foreign exchange, also known as forex, or FX trading, can be impacted by many market fundamentals, including inflation rate changes.

So what can happen to currency pairs, like the USD/GBP (GBPUSD=X) or GBP/EUR (GBPEUR=X), when traders anticipate new inflation figures – and when the data is released? Are there trading trends to watch out for?

Yahoo Finance UK asked the analysts.

How inflation impacts currency pairs

“Higher inflation weakens a currency’s buying power, meaning the affected currency is more likely to weaken. In that sense, higher inflation in the UK can devalue the pound against the dollar,” Sophie Lund-Yates, lead equity analyst, Hargreaves Lansdown, told Yahoo Finance UK.

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Read more: UK interest rates to rise less sharply as inflation drops more than expected

Therefore, traders could opt to short (sell) the USD/GBP major pair if inflation data were to come in higher for the UK, for example, in future releases.

However, this trend is not a guarantee.

“There are of course plenty of other factors at play that determine an exchange rate, but inflation is certainly not one that should be ignored. With inflation in the US on a more favourable trajectory than the UK, this could make currency comparisons an even harder task,” Lund-Yates said.

GBP reaction to UK inflation data

Giles Coghlan, chief market analyst consulting for HYCM, supported Lund-Yates' view that currencies experiencing significantly higher inflation tend to depreciate, as investors with holdings in that currency see their purchasing power being eroded.

“In turn, this leads to a decline in demand, because it makes goods and services in the country more expensive for overseas buyers,” he said.

“If we look at the GBP reaction to UK CPI data [in May] which came in hotter than expected, the currency briefly rose before falling into negative territory against the USD as investors sold the pound off on fears of a looming recession in the UK.”

Read more: Inflation fall drags sterling down

Meanwhile, inflation figures for June in the UK were released today (19 July) and came in cooler than expected, slowing to 7.9%, down from 8.7% the previous month.

Following the data release, the pound sterling declined against both the US dollar and the Euro.

Lower inflation then should, theoretically, have caused the currency to strengthen, as it is high inflation that reduces the value of a currency. However, whilst the UK inflation data is lower, it is still high compared to other countries and way above the Bank of England's 2% target.

Moreover, interest rate hikes tend to strengthen a currency. Therefore a lower inflation decreases the possibility of more central bank interest rate hikes which also weaken a currency.

All of these fundamental factors are playing into the price of the pound today but of course no previous trading pattern is a guarantee of what may happen with a currency pair in the future.

Keeping in mind the USD fundamentals

Coghlan also noted that investors need to remember to factor in the USD side of the equation.

“Indeed, with inflation falling back towards 2% in the US, it looks like the beginning of the end of the Federal Reserve’s interest rate hiking cycle. As such, with interest rate expectations falling we could see the USD weaken in the coming months, potentially creating some favourable rates for investors,” he said.

Only last week traders witnessed the USD index decline off the back of lower US inflation data.

“The US inflation rate dropped more than expected to 3%, the lowest since March 2021. As a result, the dollar index (DXY) [which values the USD against other currencies] had its worst week of the year and the third worst week in the past seven years,” independent macro analyst Piero Cingari said.

“While the market has already priced in a rate hike by the Fed next week, the probability of an additional hike by November is around 25%. Therefore, there is a strong expectation that the Fed will implement its final rate hike in July.”

Lower US inflation data also goes against the theory that the dollar should have strengthened against other currencies, which Cingari also clarified.

“A higher inflation reduces the value of the currency. That's true. But it is all about expectations — that in the near future central banks are going to increase rates to offer investors an edge against inflation.

"Then the value currency is always related to another. So EUR/USD, GBP/USD, etc. The relative strength of one versus the other is a tug of war between central banks willing to hike interest rates. Inflation is what could make a central bank more or less hawkish,” he added.

Watch: Inflation Is the Critical Variable for Markets: McIntyre

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