Bank of America Global Research argues that as inflation becomes a very serious problem, any Central Bank that blinks risks losing credibility and will see its currency weaken
"Following the recent problems with UK pension fund investments and the BoE interventions to stop a fire sale of Gilts, the "something will break" argument has become popular...Something has already broken, inflation. Both headline and core inflation have reached levels multiple times the target in most of G10 and have not even peaked yet. Unless anyone really believes that the highest inflation of the last 40 years is not a serious problem," BofA notes.
"Looking ahead, how central banks will react if "something breaks" will matter for FX. If a central bank keeps its policies tight, but uses other tools to address a market dysfunction, then the currency will not weaken and may even strengthen-indeed, the GBP was strengthening on headlines of BoE intervention. If on the other hand a central bank blinks and stops policy tightening, it risks its inflation credibility and we would expect the currency to weaken," BofA adds.