"I think that a downward surprise might, paradoxically, be good news for the pound" - City Index.

Image © Pound Sterling Live

The Pound to Canadian Dollar exchange rate set itself on course for a fourth consecutive run of losses early in the new week but could fall as far as the round number of 1.65 in the days ahead if Sterling has further difficulty navigating an approaching minefield of domestic economic risk.

Canada's Dollar climbed against almost all major currencies on Tuesday while making one of its best gains in relation to an underperforming Pound Sterling that was hampered from the outset in Europe by a glum turn in sentiments measured by the S&P Global PMI surveys.

"The Composite index dropped a point in the month to 53.9, well below forecasts (54.6) but still suggestive of decent momentum in the economy (and elevated price pressures) deeper into Q2, which will complicate policy setting for the BoE," says Shaun Osborne, chief FX strategist at Scotiabank.

"Speaking to parliamentarians a short while ago, Gov. Bailey said the BoE must respond to the risk of “persistent inflation”. MPC member Mann commented that the BoE had underestimated the persistence of inflation," Osborne writes in Tuesday market commentary.

Flash surveys suggested the recession in the manufacturing industry deepened in May at just the same time as uncertainty about the economic outlook and higher borrowing costs were reported to have hampered activity in the UK's breadwinning services sector.

Above: Pound to Canadian Dollar rate shown at daily intervals alongside GBP/USD.

The data indicated a modest ebb of economic momentum midway through the current quarter but was merely a curtain raiser for Sterling this week with inflation and retail sales numbers still to come on Wednesday and Friday.

"April data will likely show a larger drop towards 8% (from 10.1% in March), as large increases in energy prices fall out of the year-on-year comparison. We expect a further, continuous drop towards 4% by year-end," says Christian Gattiker, head of research at Julius Baer.

"However, core inflation is expected to remain high and persistent but should start to recede more meaningfully in 2024," he adds.

Wednesday's inflation report is a landmark moment for Sterling and likely also a formative influence on the medium-term outlook for GBP/CAD, one that will either confirm a slow and eventual recovery of the purchasing power lost in recent years or further erosion of it.

But this week's price action will first and foremost reflect the perceived implications for the Bank of England (BoE) Bank Rate at the coming meetings.

"I think that a downward surprise might, paradoxically, be good news for the pound, although the immediate reaction might be a straight-forward one," says Fawad Razaqzada, a market analyst for City Index and Forex.com.

"Normally, higher-than-expected inflation data means more rate hikes, thus giving the currency more reason to rise. However, when inflation is too high the negative impact of each interest rate hike on the economy tends to outweigh the benefits the currency may receive from a higher yield," he adds.

Economists and analysts widely expect the data to confirm a sizable retrenchment of inflation being underway, which could lead to further pressure on GBP/CAD if it prompts financial markets to moderate expectations for the BoE Bank Rate up ahead.

Above: Pound to Canadian Dollar rate shown at weekly intervals with Fibonacci retracements of 2021 fall indicating possible areas of medium term technical resistance while selected moving averages denote either support or resistance.

"We look for headline inflation to plummet to 8.3% y/y as base effects from last year's surge in energy prices finally kick in," writes James Rossiter, head of global macro strategy at TD Securities, in a Tuesday research briefing.

"While this would be below the MPC's forecast of 8.4% y/y, we expect services to surprise the MPC to the upside—thus adding further pressure on policymakers to deliver another 25bps hike in June," he adds.

If market pricing of the outlook for Bank Rate is unscathed by Wednesday's data, then GBP/CAD could find itself on a firmer footing from midweek on, although it and Sterling would both be vulnerable to further losses if the UK's inflation rate does not fall far enough.

UK inflation has held in the double-digits for almost eight months and any signs of it persisting at such levels for longer would hardly be helpful for any currency.

“There was a time when FX investors would sell the currency of a country where inflation was consistently higher than that of its main trading partners,” says Stephen Gallo, a global FX strategist at BMO Capital Markets, in an April review of BMO's forecasts for Sterling.