Sterling has strengthened against its peers this morning following the highly anticipated UK inflation report. While the headline figure matched the Bank of England’s (BoE) 2% target for the first time in nearly three years, persistent services inflation remains nearly double its 2000-2019 average, likely postponing the BoE's first interest rate cut until August. Before the inflation report, markets saw less than a 50% chance of a rate cut; now, the probability stands at 43.3%.

Services inflation, a key measure of inflation persistence identified by the Monetary Policy Committee (MPC), was significantly higher than the BoE expected last month, quashing hopes for a rate cut at the BoE’s meeting tomorrow. This month, services inflation has remained stubbornly high, slowing to 5.7% but still exceeding the 5.5% estimate. Another critical metric for the BoE is private sector wage growth, which continued to slow in April despite a substantial increase in the national living wage that month. Assuming supportive incoming data, we anticipate the MPC will reduce the Bank Rate by 25 basis points in August and November, though next month’s general election introduces an element of uncertainty, given the limited scope for fiscal policy adjustments.

Opinion polls indicate that the opposition Labour Party is poised to win the general election on July 4 with a significant majority. This is considered the best-case scenario for the pound. However, in the short term, a dovish BoE could have a greater influence on sterling, making the currency vulnerable, especially since it appears overvalued against the euro based on interest rate differentials.

The Australian dollar weakened overnight, influenced by disappointing Chinese economic data ahead of today's crucial Reserve Bank of Australia decision.  The AUD/USD fell to one-month lows, finding support around 0.6575.

Ahead of today's RBA decision, a Reuters poll published on 14 June found that all surveyed economists expect the central bank to maintain the current rates.  Australia’s latest monthly inflation report showed annual inflation rising from 3.5% in March to 3.6% in April, marking the second consecutive monthly increase.

While many other economies are experiencing easing inflation, Australia's inflation remains stubbornly high, making an RBA rate cut less likely. This could provide support for the AUD as we move into the second half of 2024.  Local financial markets don't anticipate an RBA rate cut to be fully priced in until March 2025.

China's key monthly activity data showed a slowdown in industrial production (5.6% in May, down from 6.7% in April) and fixed asset investment (4.2% in May, down from 4.0% in April), both missing expectations. Retail sales, however, showed improvement.

Adding to the bleak outlook, Chinese house prices remained stagnant, with new home prices down 4.3% in May compared to the same period last year.  The Chinese yuan also weakened, with USD/CNH rising 0.1%, approaching major resistance at seven-month highs.

In other markets, the euro strengthened, with EUR/USD rebounding from one-month lows.  The euro had been significantly lower over the past week after strong performances by far-right parties in the EU parliamentary elections prompted French President Emmanuel Macron to call snap national elections for 30 June and 7 July.  A Le Point poll, cited by Reuters on 14 June, found a "far-right" coalition at 29.5%, a "far-left" coalition at 28.5%, and Macron's centrist coalition at just 18%.  

Last week saw significant developments, with some asset classes experiencing their largest price fluctuations of 2024.  A combination of political turmoil in Europe, unexpected declines in US inflation, and hawkish signals from the Federal Reserve and the European Central Bank drove investors towards safe-havens like government bonds, the Swiss franc, USD and somewhat the GBP.  The narrative of US disinflation is gaining traction among market participants as the consumer, producer, and import price indices for May all came in lower than anticipated.

The Bank of England (BoE) will be under scrutiny this week.  While markets do not anticipate any policy changes from the BoE due to recent higher-than-expected inflation figures and the upcoming election in July, policymakers may use this meeting to prepare markets for a potential easing in August.  Markets currently view the beginning of the easing cycle as more likely in November, with a possible rate cut in December.  Attention will be on the number of officials voting for a cut this week (likely two) and whether Governor Bailey continues to push back against market expectations of minor policy easing this year.

This meeting occurs as the UK economy stalled in April, showing zero growth for the first time this year.  While the services sector remains strong, declines in production and construction pushed GDP into negative territory for the month. Additionally, the unemployment rate reached a two-and-a-half year high just weeks before the general election.  This economic weakness could prompt policymakers to consider easing rates sooner than the markets currently anticipate.

We view the meeting and a potential downside surprise in the UK CPI next week as potentially negative for GBP, this does not necessarily mean that GBP/USD and GBP/EUR will decline in the coming sessions.  Domestic macroeconomic and monetary policy factors in the UK will be crucial but cannot be viewed in isolation.  Economic data from the United States, such as the retail sales and industrial production reports, will also be key volatility drivers, and European politics is expected to remain the primary influence on GBP/EUR in the coming week.

The British pound continues to strengthen against the euro and has also posted gains against the US dollar this week. Investors have unexpectedly turned to the British currency as a safe haven, driven by favourable swap rates between the UK and both Germany and the US. This trend is attributed to British bond yields being less impacted by (1) the stronger-than-expected decline in US inflation and (2) the flight to safe German bonds following political turmoil in France.

Despite the British economy beginning to feel the strain of high interest rates, inflation remains elevated, posing a challenge for the Bank of England's anticipated policy easing. We still expect the central bank to cut interest rates twice this year, aligning with the Federal Reserve and one more time than their Eurozone counterparts. This outlook has buoyed the GBP/EUR pair, which is poised to rise for the fifth consecutive week, currently trading at its highest level since August 2022 (€1.1880).

Next week, we will be looking for new sources of volatility with the release of the UK CPI report on Wednesday, followed by the Bank of England's decision on Thursday. No policy changes are expected, so the focus will shift to any forward guidance for the remaining meetings of the year. Meanwhile, GBP/USD is trading slightly above its 2024 average at around $1.27, as traders await clearer directional signals.