Sterling Surges Amid Strong UK Inflation Data  

Sterling climbed above $1.27 at inter-bank (IB) against the US dollar and €1.20 at IB against the euro this morning, buoyed by unexpectedly high UK inflation figures. The data adds pressure on the Bank of England (BoE) to postpone further interest rate cuts until next year, enhancing the pound's yield appeal.  

Annual headline CPI increased to 2.3% in October, surpassing the forecast of 2.2% and up from 1.7% in September. The rise was driven largely by higher housing and household services costs, particularly electricity and gas prices, following the 10% hike in the UK energy price cap for October. This marked the largest monthly inflation jump since October 2022. Core inflation also exceeded expectations at 3.3%, while services inflation edged back to 5%, consistent with BoE forecasts.  

Despite cutting interest rates twice to 4.75%, the BoE is now expected to delay further reductions. A 25-basis-point cut initially anticipated in December is now projected for February, with markets pricing the next full cut for March. Investor expectations for cumulative easing through 2025 have been reduced, with 59 basis points now priced in, down from nearly 67 yesterday.  

While stretched speculative bullish positions may pose downside risks to sterling, today's inflation report could fuel further short-term gains for the pound.

Geopolitical Tensions Spark Shift to Safe Havens  

Renewed tensions between Russia and the US triggered volatility across financial markets yesterday, driving investors toward safe-haven assets. Treasury bonds, gold, the US dollar, Swiss franc, and Japanese yen all gained, while the Polish zloty suffered the steepest losses due to its geographical proximity to the conflict.  

The resurgence of geopolitical risks followed updates to Russia’s nuclear doctrine and reports of a Ukrainian missile strike within Russian territory. Russia has warned that Ukraine's use of Western-supplied non-nuclear missiles against Russian targets could provoke a nuclear response, heightening fears of escalation.

Limited Upside for EUR/USD Amid Persistent Headwinds  

Despite a brief reprieve from selling pressure, the euro lacks a strong foundation for a significant recovery against the US dollar. Weak economic conditions in the Eurozone, political uncertainties, trade tariff risks, and widening interest rate differentials continue to weigh on the currency, suggesting sustained weakness in the medium term.  

Since Trump’s re-election, EUR/USD has declined over 3%, and the drop extends to over 6% since the end of September. The $1.05 level remains a critical psychological support, but further downside appears likely without clear policy actions from the new administration. Trade tariffs pose a significant risk for EUR/USD volatility, while widening rate divergence is expected to sustain downward pressure on the pair.  

Although potential stimulus measures from China could lend support to the euro, current policy announcements have underwhelmed, leaving little room for optimism about a reversal in EUR/USD's downward trend.

Markets Brace for Policy Shifts and Oil Supply Concerns

Markets are still grappling with the complexities of President-elect Donald Trump’s policy proposals, with investors closely monitoring developments from his incoming administration. Meanwhile, oil prices surged over 3% on Monday, marking the largest daily gain since early October. The rally was driven by the U.S. authorizing Ukraine to deploy long-range missiles within Russia and a production halt at Norway’s Johan Sverdrup oilfield—Western Europe’s largest—following an onshore power outage, intensifying fears of supply constraints in the North Sea crude market.

ECB Policy Bets Shift Amid Trade Tensions and Euro Gains

Traders have scaled back expectations for policy easing by the European Central Bank (ECB) in the coming year, with options markets now pricing in 135 basis points of rate cuts through the end of 2025, down from 147 basis points last week. This adjustment reflects growing concerns about the potential impact of Donald Trump’s proposed tariffs on European goods, which could heighten the risk of an economic downturn in 2025 and 2026 while fuelling another wave of inflation.

The interplay between growth, inflation, and trade tensions adds uncertainty to the ECB’s outlook, potentially prompting a flexible policy response to navigate the unpredictability of a new trade spat. The euro has benefited from the repricing, strengthening for a second consecutive day against the US dollar—a milestone last seen three weeks ago. German Bundesbank President Joachim Nagel emphasized that trade-related inflation spikes might necessitate higher interest rates.

EUR/USD has moved further from the $1.05 level, nearing $1.06. However, short-term market sentiment remains bearish, with the 1-month delta risk reversal dropping to its lowest point since July.

Pound Mixed as Markets Eye BoE Testimony and Policy Uncertainty

The pound had a mixed start to the trading week, losing ground against pro-cyclical and high-beta currencies but gaining against safe havens. GBP/USD remains supported by ongoing USD profit-taking, with the pair nearing the $1.27 level. However, reduced expectations for Federal Reserve easing and uncertainty surrounding the Bank of England’s (BoE) policy stance could limit further gains.

BoE Governor Andrew Bailey and other policymakers are set to testify before Parliament’s Treasury Committee on inflation and the economic outlook. Their remarks could significantly shape market expectations regarding future interest rate cuts, influencing GBP/USD movements. Current market pricing suggests only a 15% chance of a BoE rate cut next month, with just over two cuts anticipated by this time next year. Meanwhile, pound options traders are preparing for higher volatility in 2024, driven by the U.S. presidential election outcome and rising trade and sentiment risks.

Fed Signals and Dollar Surge Shape Investor Sentiment  

Last week, investors were relieved when the Consumer Price Index (CPI) met expectations, alleviating fears that rising inflation would halt the Federal Reserve's plans to cut interest rates in December. However, on Friday, Fed Chair Jerome Powell struck a cautious tone regarding the pace of rate cuts, dampening the market's recent risk rally and tempering the optimism that had propelled U.S. equities to record highs.  

Meanwhile, the U.S. Dollar Index has surged approximately 7% over the past seven weeks, marking its strongest performance over such a period since 2022. Options trading activity and positioning data indicate traders are anticipating further gains in the dollar. Additional upside risk for the greenback may stem from key policy proposals by former President Donald Trump—particularly tariffs—that may not yet be fully reflected in current market prices.

Pound vs. Euro: UK Data Risks and Eurozone Headwinds  

The Pound Sterling may face further losses against the Euro in the coming week if UK inflation and PMI figures fall short of expectations. Last week, the Pound to Euro exchange rate (GBP/EUR) dropped 0.65%, despite hitting a two-year high of 1.21 at inter-bank (IB) on Monday, last week. This peak reflects a generally constructive outlook for the Pound against the Euro, supported by the UK's higher interest rates compared to the Eurozone.  

Broader euro weakness stems from political uncertainty in Germany and concerns about potential U.S. tariffs under a future Trump administration. In the near term, GBP/EUR appears to be consolidating its recent gains, with resistance at the 1.21 highs for 2024. On the downside, strong support is seen at 1.1850, aligning with the lows recorded in November, October, and September.

Key UK Inflation Data and Geopolitical Tensions to Shape Markets  

This week’s UK inflation data, set for release on Wednesday, will be a critical focus for markets. Inflation is expected to rise to 2.2% year-on-year in October, up from 1.7% in September, signalling an acceleration in price pressures.  

Adding to market dynamics is President Biden’s recent decision to authorise Ukraine to deploy U.S.-made long-range missiles for strikes deep into Russian territory. Geopolitical tensions like these often push investors toward safe-haven assets such as the U.S. dollar, potentially boosting its value further.

Dollar Flirts with New One-Year High

The US dollar index briefly reached a fresh one-year high on Thursday before pulling back sharply. This retreat came as little surprise, given the dollar had entered overbought territory, as indicated by the 14-day relative strength index surpassing 70. Even so, the index has climbed more than 6% over seven weeks, marking its most robust performance over such a period since 2022. Renewed risk aversion on Friday lent further support to the safe-haven dollar, while equity markets faltered after Jerome Powell hinted that the Federal Reserve sees no urgency to lower interest rates and expects PCE inflation to rise.

This week’s surge in the dollar was partly fuelled by President-elect Donald Trump’s hawkish cabinet appointments and the Republicans retaining control of the House, delivering Trump a political trifecta that heightens prospects for his policy agenda. Economic momentum had already shifted in favour of the US, prompting another hawkish reassessment of the Fed’s rate-cutting trajectory, which benefits the dollar via both fiscal-monetary and trade policy channels. Although expectations for sustained US growth into 2025 and Trump’s policies may outweigh seasonal dollar weakness through the year’s end, uncertainty remains significant. The critical issue now is the scale and pace of forthcoming policy changes.

On the data front, Wednesday’s CPI figures were complemented by PPI data signalling inflationary pressures in segments of the economy, which could constrain the Fed’s easing cycle. Core goods prices recorded their largest increase since February, further supporting projections for a rate cut in December. Overnight swaps reflect a 46% likelihood of this, with only two rate cuts anticipated over the next five Fed meetings.

ECB Rate Cut Fully Priced In

The euro has suffered five consecutive daily declines, falling to the mid-$1.05 range—the lowest level since October 2023. Minutes from the European Central Bank’s latest meeting strongly indicated policymakers favour further interest rate cuts, potentially as soon as December. Markets have priced in a 100% probability of policy easing. As inflation concerns fade, growth risks have become the dominant concern. Trump’s election, the prospect of tariff wars, and instability in Germany’s governing coalition have added to the challenges facing European policymakers.

The situation worsened in September, with industrial production recording its second-largest monthly drop this year, declining by 2%. Manufacturing production has shown annual growth in only one month since the start of 2023, highlighting the European industry’s struggles. Lower interest rates in 2024 are likely to be welcomed, but the euro faces continued downward pressure. Without a clear catalyst for recovery, bearish sentiment towards the currency is expected to persist.

UK Growth Stagnates Through Summer

The pound briefly rebounded from a four-month low near $1.26 to reach $1.27 before relinquishing some of its gains following disappointing UK GDP data. The economy contracted unexpectedly in September, resulting in just 0.1% growth for the third quarter.

The dominant services sector expanded by 0.1%, while construction grew by 0.8%. However, industrial production fell by 0.2%, painting a lacklustre picture for the new Labour government, which had pledged to achieve annual growth of 2.5%, the fastest in the G7. Compounding Britain’s economic challenges is the spectre of a new wave of protectionism following the US election. Nonetheless, the direct impact on the UK is expected to be minimal, given the US maintained a goods trade surplus of $10.5bn with Britain in 2023, with the UK accounting for just 2.1% of US goods imports.

Sterling faces an uphill battle to recover to $1.30 against the dollar, as tighter US monetary policy, driven by the inflationary effects of tariffs, continues to weigh on the currency. Additionally, sterling’s pro-cyclical nature makes it particularly sensitive to market volatility. With equities and cryptocurrencies losing momentum, safe-haven demand is likely to bolster the dollar, keeping the pound under pressure in the near term.