The Bank of Japan raised interest rates, while Fed Chair Jerome Powell suggested the possibility of rate cuts in September. Despite these developments, the British pound remained stable as investors are cautious ahead of the Bank of England's decision. Unlike previous well-anticipated meetings in London, today's decision presents uncertainty as economists and markets are divided on whether the dovish members will succeed in pushing through a rate cut.

The main argument for easing policy is the significantly higher real rate (policy rate minus inflation) in the UK compared to the United States and Eurozone. Although headline inflation has decreased to 2.1%, the benchmark rate remains at 5.25%. On the other hand, hawks within the Monetary Policy Council (MPC) argue that the economy is robust, having grown by 0.7% in Q1. Additionally, services, rent, and wage inflation remain high and persistent, with leading indicators suggesting a slight reacceleration of inflation. Nonetheless, markets seem to expect the Bank of England to initiate a cutting cycle, as indicated by the 2-year yield falling to its lowest level since March 2023, at 3.8%.

The GBP/USD has been flat this week but could see increased volatility today with the BoE decision and tomorrow with the US labor market report. The current intra-week range of $1.2800 to $1.2880 is likely to be surpassed due to these significant risk events.

The euro briefly dipped below $1.08 for the first time in over three weeks, driven by a mix of macroeconomic reports from the Eurozone. Despite this, European equity markets closed positively as investors processed fresh earnings reports, while the bond market saw continued interest. German front-end bond yields fell for the sixth straight session, reaching a near seven-month low at 2.54%.

Preliminary figures showed the Eurozone economy grew by 0.3% in Q2, exceeding expectations, with France, Italy, and Spain leading the growth. Conversely, Germany's economy unexpectedly shrank by 0.1% quarter-on-quarter, against predictions of a 0.1% increase, with significant declines in investments in equipment and buildings due to high interest rates straining the industrial sector.

Inflation in Spain decreased more than anticipated to 2.8% year-on-year, while Germany saw an unexpected rise in inflation to 2.3% year-on-year, compared to the expected 2.2%. Food prices rose and service inflation held steady at 3.9%, while energy costs declined more slowly. The CPI increased by 0.3% from the previous month, the largest rise in three months. Investors are still expecting a 25bps rate cut by the ECB in September.

Despite the influx of data, one-week EUR/USD realized volatility remains near 2024 lows due to prevailing caution as markets prepare for this week’s Fed and BoE meetings. The Euro Index fell by 0.16% for the second consecutive session, reaching a four-week low.

The UK yield curve has disinverted for the first time since May 2023 and is expected to steepen further as traders anticipate the Bank of England (BoE) will soon start cutting interest rates, with more reductions likely over the next year. Recently, sterling has been influenced by broader market sentiment, dropping below $1.29 against the US dollar last week. The focus now shifts to the BoE meeting this Thursday to see if the pound can make another attempt at $1.30.

The decision on whether the BoE will cut rates this week remains uncertain. Expectations for a rate cut increased significantly after the June meeting, where policymakers revealed that the decision to hold rates was “finely balanced,” with two members voting for a cut. Since then, a new government has taken office, and the latest PMI readings indicate that cost pressures are easing, driven by decreasing output prices in the services sector, which has been a significant contributor to consumer inflation. Despite slight increases in services inflation and private sector wages, along with strong survey results, we believe the market may be underestimating the likelihood of a rate cut this Thursday. This could expose the pound to short-term downside risk.

Nevertheless, the stronger UK economic recovery, improving consumer confidence, and the UK’s renewed engagement with the EU are all positive factors for the pound. As a result, our long-term outlook for GBP remains bullish.

The Pound to Euro exchange rate fell last week, as our previous Week Ahead Forecast predicted. We expect this pressure to continue leading up to Thursday's crucial decision from the Bank of England.

Over the past two weeks, GBP/EUR has declined from its 2024 highs. However, we see this weakness as part of a broader uptrend, with the overall outlook remaining positive. The exchange rate is still well above its 50-, 100-, and 200-day moving averages, and only when these levels are breached would we consider the uptrend at risk.

In the coming weeks, we anticipate a potential test of 1.20 (see forecasts from over 30 investment banks for Q3 and year-end). In the short term, we expect more room for weakness, with a test of 1.18 likely before the rally resumes. Last week, the exchange rate fell below the 21-day moving average, which is now limiting intra-day advances (currently at 1.1854), supporting our expectation of pre-Bank of England nerves pushing the rate down.

The Pound is experiencing crowded positioning, with many investors betting on further advances. This heavy one-way positioning means any disappointments in data or events could trigger a significant 'washout' and a deeper pullback.

Currently, markets see slightly more than a 50% chance of a rate cut on Thursday. Last week's weakness in the Pound reflects these recalibrated expectations, as the odds of a cut were closer to 40%.

If the Bank of England does not cut interest rates, it could provide some relief to the Pound, allowing for a rebound by the end of the week. However, a firm commitment to a September rate cut would create a 'dovish' hold, which might not support a strong rebound in the Pound.

Overall, we expect near-term weakness to give way to a resumption of the rally in the coming weeks.