UK Inflation Falls Below BoE Target, Pound Drops as Rate Cuts Loom

Headline inflation in the UK has dipped below the Bank of England’s (BoE) 2% target for the first time in three years. The September inflation rate came in at 1.7%, lower than the 1.9% forecast and the previous 2.2%. Core inflation also eased to 3.2%, versus the anticipated 3.4%. This larger-than-expected drop in inflation has led to a decline in the pound, alongside falling 10-year gilt yields, as the likelihood of more BoE rate cuts increases.

The BoE has been particularly focused on services inflation, which has influenced its monetary policy decisions. Governor Andrew Bailey’s recent comments suggested that the central bank might adopt a more aggressive approach to rate cuts if inflation continued to fall. In a significant development, services inflation dropped to 4.9%—the largest single-month decrease since 2020—compared to the forecasted 5.2% and the previous 5.6%. This data reinforces the ongoing disinflation trend in the UK, which is further supported by recent signs of a cooling labour market.

As a result, market expectations for rate cuts have shifted. Overnight index swaps are now pricing in a 30-basis-point rate cut in November, up from the 22-basis-point expectation before the CPI data, with a total of 44 basis points of easing anticipated by year-end.

The pound has taken a hit in response, with GBP/USD dropping from $1.3077 to just under $1.2990, its lowest level since mid-August. The next downside targets are the 100-day moving average at $1.2954, followed by the 200-week moving average at $1.2844, and the 200-day moving average at $1.2794.

Oil Price Drop Drives Dollar Weakness Despite Softer US Data

Despite recent weaker US economic data, we believe the primary factor behind the dollar's decline was the movement in oil prices. This is evident as the dollar's weakness occurred before the European markets opened, ahead of key macro data releases. Furthermore, the six-month correlation between EUR/USD and Brent crude oil is at its most negative level since early 2000. Oil prices fell sharply overnight, dropping by as much as 5.6% following reports that Israel would not target Iran’s oil facilities. This decline in oil prices reduced inflation expectations and subsequently led to lower US Treasury yields, particularly at the long end of the curve. Short-term yields also fell slightly, likely due to recent comments from Federal Reserve (Fed) officials hinting at modest rate cuts ahead.

Despite this, we expect the overall positive trend for the US dollar to persist, provided economic data stays resilient. Historically, both volatility and the dollar tend to strengthen in the lead-up to US elections. This is particularly relevant now that a 50 basis point rate cut from the Fed next month is off the table.