Deteriorating global risk sentiment pushed the euro down against its G10 counterparts. The STOXX50 index plunged to a three-week low, while European yields inched higher. The yield on Germany's 10-year benchmark bund climbed to 2.68%, reaching a six-month high, and the 2s/10s curve steepened to -36bps, nearing a three-week high.

May's preliminary report showed Germany's headline consumer inflation rate rising to 2.4% year-on-year, matching market expectations. This marks the first inflation increase in five months, driven by higher prices in services and food, despite further declines in goods prices. The core inflation measure, excluding volatile food and energy components, remained steady at 3% year-on-year. Monthly momentum slowed more than anticipated, dropping to 0.1% from 0.5% in the previous report, but the EU-harmonized inflation rate unexpectedly increased to 2.8% year-on-year, above the 2.7% forecast. Although this rise in the harmonized measure is unlikely to prevent the ECB's expected rate cut next Thursday, it raises concerns about the central bank's flexibility for further easing in the second half of the year. The ECB's Governing Council appears divided, with most policymakers hesitant about a consecutive rate cut in July, while France's Villeroy suggested not ruling out such a move.

In the currency markets, EUR/GBP dropped as much as 0.3% to 0.84838, its lowest since August 2022, before recovering, as the Bank of England is increasingly expected to lag behind the ECB in cutting interest rates. EUR/CHF retreated from multi-month highs, and EUR/USD fell by over 0.4%, marking its largest one-day drop this month, though it remains supported at its 100-day SMA. As we approach the ECB's rate decision on June 6, sentiment towards the euro is turning more bearish. One-week EUR/USD risk reversals are now the most euro-negative in nearly four weeks.

The British pound climbed to its highest level since mid-March against the US dollar yesterday, driven by improved global risk sentiment and thin trading conditions due to holidays in the US and UK. GBP/USD is hovering just below the $1.28 mark, nearly 4% above its 2024 low of around $1.23 and just one cent short of its 2024 high. Against the euro, sterling is near nine-month peaks, only 30 pips shy of €1.18 and almost 2% higher than its 2024 low of €1.1560 recorded at the end of April.

The primary factor behind the recent strength of the pound was the hotter-than-expected inflation report published last week, which drastically reduced the probability of a June rate cut by the Bank of England (BoE) from 50% to 10%. Currently, money markets are pricing in fewer than two BoE rate cuts for 2024, with a total easing of 30 basis points expected by year-end, which we consider overly dovish. Consequently, yields on UK Gilts surged to one-month highs, and the UK-US yield spread reached a two-month high, propelling GBP/USD to an 11-week peak.

Election news has not negatively impacted sterling so far, but this could change if polls show the incumbent Conservatives closing the gap, increasing uncertainty. Nonetheless, neither party is proposing radical fiscal policy shifts, and both are likely to avoid spooking financial markets, unlike former PM Truss did in October 2022. Therefore, this election campaign might be less volatile, with the direction of UK assets, including the pound, likely driven more by fundamental economic factors and the timing and pace of BoE rate cuts.

While the spot market has remained relatively calm regarding election news, the options market reflects anticipated volatility, with 2- and 3-month implied volatilities, which cover the election date, spiking higher. The biggest risk to sterling in the coming months, which could push GBP/USD back below $1.25, is a surprise June rate cut by the BoE or a hung parliament in the election, but both scenarios are currently considered tail risks.

The British Pound declined against both the Euro and the Dollar following a significant drop in UK retail sales for April. However, markets appear to be looking past these figures due to the impact of adverse weather conditions.

According to the ONS, retail sales dropped by 2.3% month-on-month in April, far below the expected -0.4%. Annually, sales fell by 2.7%, missing the forecasted -0.2%.

Upon the release of this data, the Pound to Euro exchange rate initially fell but quickly rebounded to around 1.1737. Similarly, the Pound to Dollar exchange rate dropped to 1.2672 before recovering to 1.2690.

The brief dip in the Pound indicates that investors are disregarding the weather-affected figures, anticipating a rebound in May. Additionally, retail sales are expected to recover in the coming months, supported by a strong job market and declining inflation.

Although the monetary value of retail sales has steadily increased in recent months, the volume of goods sold continues to decline. This trend is due to inflation, which is driving up costs and reducing the quantity of purchases.

With inflation expected to fall back near the Bank of England's 2.0% target in the coming months, the value of sales could stabilise. Meanwhile, increasing real incomes may lead to a rise in sales volume.

The Pound is likely to withstand any post-retail sales volatility due to reduced expectations for a Bank of England interest rate hike following Wednesday's inflation report.