Bank of England is firmly ensconced in a quagmire.

Rhetoric is heating up in the UK over inflation. The BOE is feeling the heat; Mervyn King had to deliver the “I’m sorry, but this inflation stuff is tricky” letter to the chancellor of the exchequer; and BOE-member Sentence is screaming for rate hikes.

Bank of England is firmly ensconced in a quagmire. If the bank hikes interest rates to tame seemingly rising inflation it risks pushing the economy into a deepening recession. If it doesn’t raise rates, the bank may find itself far behind the inflation curve. We don’t envy Mr. King (our CB chief fav).

Though this situation isn’t completely analogous, we have seen the Bank of England blink before at a key moment in currency lore past. It was the summer of 1992, if memory serves. Germany was hiking rates to attract capital for its leveraged buyout of East Germany. The pound was a part of the exchange rate mechanism (all currencies pegged to the D-mark) and pegged at quite a lofty level thanks to good old Maggie. Yet, the country was staring down the barrel of a looming recession (and it was election time to boot). It was politically risky for the Bank of England to raise interest rates—a requirement as part of the ERM to follow German monetary policy at the time (isn’t one monetary policy fits all such a beautiful thing). Pressure grew on the bank, Soros shorted, the Bank of England blinked, and politicos decided it was time to exit ERM stage left. The pound fell like a stone and never to return to the single eurozone currency experiment.

Thus, the British pound is being influenced by history, and two different key factors – the fluctuations in UK inflation expectations and risk appetite (for which the S&P 500 serves as our proxy.) In the short-term, the British pound could feel a boost from rate hike talk. In the medium-term, we think the British pound suffers at the hand of a stagflation scenario. In the longer-term, if the UK economy is able to cleanse itself more quickly than the eurozone and/or the US and BOE interest rate policy moves toward normalization, then the British pound might be a horse to ride.

GBPUSD and S&P 500 Daily:

There sits big-time overhead resistance for the British pound. Either the S&P needs to hold up long enough for the pound to break through there, or Sentence better start finishing his rate hike comments with exclamation points.