Tumultuous Day for the British Pound and UK Markets
The British pound and UK equity benchmarks experienced sharp declines yesterday, with bond prices tumbling and yields surging. The 10-year gilt yields reached their highest level since the 2008 financial crisis, while 30-year yields climbed to levels not seen since 1998.
The pound fell by over 1%, with GBP/USD hitting its lowest level in more than a year. Breaking through its Bollinger band and last year’s lows, the pair is now approaching the October 2023 low of $1.2037. Sterling faced significant volatility across G10 currencies, with daily declines exceeding two standard deviations compared to the average performances over the past five years. Even GBP/EUR, which had remained stable above €1.20 for weeks, has dropped closer to €1.19.
This turmoil was largely triggered by weak demand in recent UK government debt auctions. The resulting surge in long-term borrowing costs pushed bond yields to multi-decade highs. While higher yields could theoretically support the pound, persistent economic concerns—characterized by weak growth, sticky inflation, and fears of stagflation—outweighed any potential benefits.
These events signal a broader reassessment of the UK’s economic prospects under the Labour government. Optimism about political stability has given way to worries over rising taxes, public spending, stagnating growth, and inflation. The market's reaction mirrored the turmoil of the 2022 Liz Truss budget, although the current situation is less severe. However, the UK’s persistent current and capital account deficits leave the pound exposed to foreign investor sentiment.
Adding to the pressure, the pound seems disconnected from the expected monetary policy path. Divergences between GBP/USD and UK-US yield spreads highlight this growing gap. The Bank of England’s policy trajectory compounds the challenge; while markets expect minimal rate cuts, stagflation fears have muted any potential boost to sterling. Conversely, stronger signals of rate cuts could weigh further on the currency.
For the pound to stage a recovery, a combination of stronger economic data and improved confidence in fiscal policy will be essential. Until then, sterling remains vulnerable to both domestic and international pressures.
US Dollar Gains Momentum Amid Economic Optimism and Fed Hawkishness
The US dollar has regained strength, buoyed by encouraging economic data and hawkish minutes from the Federal Reserve's December meeting. These developments have validated the Fed’s pivot to a more aggressive stance on rate cuts, driving the dollar's rebound against major currencies. Long-term Treasury yields are also nearing 5%, reflecting this optimism. However, much of the positive sentiment appears to be already factored into the dollar and bond markets.
Attention now shifts to Friday’s monthly jobs report, a key data release ahead of the Fed’s next monetary policy decision. This report will provide the final labour market update before the Fed enters its pre-meeting blackout period. Expectations are for US payrolls to have increased by 163,000, with the unemployment rate remaining steady at 4.2% and average hourly earnings rising 0.3% month-over-month. The chart below illustrates how closely inflation and labour market data influence market expectations for the Fed's policy trajectory. The Fed funds rate pricing has closely tracked surprises in inflation and employment metrics, highlighting the ongoing dominance of the Fed’s dual mandate in shaping market sentiment.
October marked a turning point for this proxy indicator of the Fed’s mandate and the dollar's performance. While the index has plateaued since November, the dollar's rally has continued, driven by two key factors: the "Trump trade" and growing political risks outside the US. Together, these dynamics have reinforced the Greenback’s resilience in the face of evolving market conditions.
EUR/USD Struggles Amid Diverging Economic Trends
The EUR/USD pair experienced a turbulent session yesterday and is trading near $1.03 this morning. The US dollar continues to gain strength this week, supported by strong economic data, including robust employment numbers and improved consumer confidence. These indicators have reinforced expectations of a hawkish Federal Reserve, boosting the greenback.
In contrast, the Euro faces headwinds from weak economic data in the Eurozone. German factory orders unexpectedly declined in November, signaling deeper economic challenges. Additionally, German retail sales contracted during the same period, raising concerns about the health of the Eurozone’s largest economy. These disappointing figures, combined with rising energy prices and the ongoing energy crisis, have weighed heavily on investor sentiment toward the Euro.
The outlook for EUR/USD remains uncertain. If US economic data continues to surprise on the upside and the Fed maintains its hawkish stance, the Euro may face further pressure. However, signs of weakness in the US economy or a shift toward a more dovish Fed could offer some relief to the common currency.
