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.

Stocks jump, oil slumps

US stocks jumped to a fresh peak, with the S&P500 notching its 46^th record close of the year, fuelled by a rally in the tech sector as investors look to earnings for vindication of their bets that the US will avoid a recession. The US dollar index continues to press higher, clocking its longest daily winning streak since 2012.

As we’ve seen this month, a measure of underlying US inflation in September came in hotter than expected, while the most recent snapshot of the US labour market showed a drop in unemployment amid solid hiring. This has prompted investors to pull back bets the Fed will again cut its benchmark interest-rate by an outsize 50bps at its upcoming meeting in November. Thus, relative growth and yield differentials remain bullish drivers of the dollar, as does safe haven demand, amidst multiple geopolitical risks. However, Israeli Prime Minister Benjamin Netanyahu agreed to limit retaliation against Iran to military targets, which has triggered a 4% drop in oil prices overnight. Extended declines in oil prices in the short term appear likely amid signs of easing geopolitical risks combined with lingering doubts around the effect of China’s stimulus.

This could cool dollar demand. We are expecting a period of consolidation or a pullback in the dollar index, despite the plethora of bullish drivers, mainly due to it being overbought via the Relative Strength Index on the daily chart, but also because of the lack of fresh positive catalysts.

Pound still soft after mixed jobs data

The British pound remains on the soft side after a mixed set of data on the UK labour market. The unemployment rate fell to 4% as expected, marking the lowest level since the three months ending in January. Average weekly earnings including bonuses were up 3.8% y/y as expected, but marked a fresh low since November 2020.

The other key takeaways from the jobs report saw payrolled employees decreased slightly by 15,000, more than the 3,000 forecast, but rose by 113,000 y/y. Economic inactivity dropped to 21.8%, whilst vacancies continued to decline for the 27^th consecutive quarter, now at 841,000. The vacancies to unemployment ratio remains around one standard deviation higher than the 2000-2019 average. The bottom line is that a cooling UK labour market is bringing down wage growth, which will please Bank of England (BoE) policymakers. The BoE is keeping a close watch on these indicators as it seeks to gauge how far inflationary pressures in the economy are easing and therefore how fast to cut interest rates. Traders are more likely to wait for tomorrow’s CPI data though in assessing whether the BoE delivers a quarter-point interest-rate cut in November.

As such, pricing of BoE rate expectations barely moved after today’s jobs data. UK gilt yields are slightly higher, but GBP/USD remains in the middle of its $1.30-$1.31 range its been stuck within for most of October. GBP/EUR is moving closer to €1.20 though as a result of EUR/USD dropping below $1.10.

Euro trending below $1.09

The euro continued to build on its losses from last week and fell to a fresh two-month low at $1.0880. The negative momentum remains the driving force behind the move as investors await crucial US data and the rate decision from the European Central Bank (ECB) later this week for new impetus.

With a depreciation of around 2.2%, October is shaping up to be the worst month for EUR/USD year-to-date. This would be in line with both seasonality trends and previous US election cycles as the euro falls going into Q4 and the election. Former president Donald Trump’s rise in betting markets has been beneficial for the US dollar and stocks of companies that would benefit from a red sweep.

This repricing could continue to pressure pro-risk currencies and EM FX. The results of the ECB’s lending survey and Eurozone industrial production coming up later today could become new catalysts for confirming the weakness in the euro or stopping its fall for now.

This week, GBP/EUR rate faces significant downside risks, with UK inflation and wage data set to play a decisive role. Despite some technical support around €1.1950, driven by the 21-day moving average, the Pound remains vulnerable. While GBP/EUR has pulled back from its recent highs near 1.20, technical indicators suggest room for further gains, with a retest of 1.1975 possible in the near term. However, if wage growth or inflation underperforms, the market’s focus will shift to potential rate cuts, which could undermine this positive setup and put further pressure on the Pound.

GBP/USD is also struggling to maintain ground, with the pair trading near mid-1.3000s, not far from last week’s one-month low. The USD remains bolstered by diminishing expectations of further large interest-rate cuts from the Federal Reserve, alongside a risk-off sentiment driven by ongoing geopolitical tensions in the Middle East. These factors are keeping demand for the safe-haven Dollar high. Meanwhile, growing expectations that the Bank of England may accelerate its rate-cutting cycle, potentially starting in November, are weighing heavily on the Pound, further pressuring the GBP/USD exchange rate.

Market sentiment around UK interest rates is at a critical juncture, with upcoming wage and inflation data likely to dictate the Pound's direction. Current market pricing suggests a 90% likelihood of a Bank of England rate cut in November, which could be reinforced if this week’s data underwhelms. While recent UK economic figures, such as a 0.2% GDP growth for August and stronger-than-expected manufacturing data, provided some temporary support, the broader outlook remains challenging. Meanwhile, in the US, favourable inflation data has reduced the urgency for further Fed rate cuts, limiting upside potential for the Pound in the GBP/USD pair.

British Economy Expands in August, But Pound Faces Headwinds

The British economy grew by 0.2% in August, rebounding from zero growth in July, in line with market expectations. Despite this positive economic data, the pound has shown little to no reaction. After appreciating against 70% of its global peers in September, the pound has only gained against 16% of them so far in October. The primary drag on the currency has been a dovish repricing of Bank of England interest rate expectations, although UK bond yields have risen to their highest levels since July, likely in response to higher US yields and anticipation of the upcoming UK Budget at the end of the month.

Additionally, the rise in oil prices and increased demand for safe-haven assets due to escalating tensions in the Middle East have further limited demand for risk-sensitive currencies, including the British pound. Energy-importing nations like the UK have been particularly impacted. However, the euro appears even more vulnerable, as reflected by the pound's modest 0.7% decline against the euro this month, compared to a larger 2.5% drop against the US dollar. With the dollar benefiting from safe-haven flows ahead of a tight US election, GBP/USD downside risks are increasing, and a break below $1.30 could signal further declines. A Republican victory in the US elections poses a significant risk to the pound, given its strong correlation with risk sentiment and the dollar's likely short-term rally in such a scenario.

Mixed US Economic Data Fuels Fed Rate Cut Speculation

Market participants evaluated a slightly higher-than-expected US inflation report alongside a worse-than-expected jobless claims figure. The contrasting data signals ongoing uncertainty in the tug-of-war between the labour market and inflation. However, the overall market reaction saw an increase in bets on a potential quarter-point rate cut by the Federal Reserve in November. This shift led to the largest daily drop in two-year US Treasury yields for the month, while the US dollar index marked its ninth consecutive day of gains.

US Election Uncertainty Drives Hedging Costs and FX Volatility

Markets have begun factoring in the risks surrounding the upcoming US election, leading to increased hedging costs and heightened foreign exchange (FX) volatility. The tight race between Trump and Harris has become too close to predict, with polls and betting markets fluctuating within the margin of error. As the November 5 election approaches, market price swings are expected to continue as shifting implied winning probabilities lead to constant repricing. A lean towards Trump in betting polls could boost the US dollar, while a rise in support for Harris may relieve some pressure on emerging market currencies.

French Budget Constraints and ECB Expectations Weigh on Euro

While not the primary factor behind the euro's recent weakness, French budgetary constraints have added to the downside pressure on the currency. The European Central Bank has signalled that next week’s October meeting is "live," with markets anticipating a 25 basis point cut in benchmark policy rates. Meanwhile, expectations for a Federal Reserve rate cut have diminished, causing the rate differential to move against the EUR/USD pair. As a result, the currency pair is likely to close the week below the $1.10 level after remaining above it for seven consecutive weeks.