9 January 2014 FX Blueprint: Thin end of the wedge Theme 1t3: - Home Counties trump Mounties ▪ Inflation risks and potential FDI inflows should keep sterling supported this year, but a widening current account deficit and stronger USD will constrain gains versus the euro and dollar. We are moderately bearish EUR/GBP and GBP/USD. forecasting 80p and 1.54 by end-year respectively. • As an outright trade we prefer buying GBP versus CAD, on which we are more bearish. It remains vulnerable to an equally-large current account deficit, CE-flow unwinds and unwinding internal imbalances. The UK domestic demand cycle has kicked in quicker, stronger and more sustainably than anticipated. We see inflation and FDI inflows as being the major source of upside risk for GBP next year. Inflation, not deflation to be theme in 2014 Last year was all about UK growth expectations. This year, the risk is attention turns to prices. First, even though recent inflation prints have surprised to the downside, pipeline pressure is building. Productivity is not recovering as quickly as the BoE is expecting, leading to a much faster than expected drop in the unemployment rate. In turn, wage inflation could accelerate sharply in 2014 (chart 1). Second, the starting point of inflation is much higher in the UK than the rest of G10. Any turn in the trend will focus minds much more quickly than elsewhere. With the first BoE rate hike still only priced for mid-2015 (a bit earlier than the Fed), there is plenty of potential for near-term yield support as price pressure builds. Outside of monetary policy, FIN is another source of support. Excluding the Verizone-Vodafone deal, UK inbound M&A has been muted by pre-crisis standards. But UK deal-flow is pro-cyclical, tracking the broad trends in equities and global M&A transactions well. Our equity analysts are positive on both this year. Add to that the UK government's increasing dedication to attracting foreign