Sterling is rising across the board after data released this morning showed that UK inflation neared the Bank of England’s (BoE) 2% target but did not slow as much as expected. This has left the likelihood of a June rate cut unchanged at around 50%. GBP/USD and GBP/EUR have both reached new 2-month highs at $1.2760 and €1.1740, respectively.

Inflation peaked at 11.1% in October 2022, its highest in 40 years. Since then, there has been significant progress in reducing price pressures, with the headline consumer price index dropping to 2.3% year-on-year in April—its lowest since the summer of 2021 and a substantial decrease from the 3.2% recorded in March. However, this fall in inflation did not meet the consensus forecast of 2.1%, which was also the BoE's expectation. Prices of electricity, gas, and other fuels fell by 27.1% year-on-year, the largest drop since records began in 1989. Additionally, core inflation, which excludes volatile food and energy costs, fell to 3.9% from 4.2%. Services inflation, closely monitored by the BoE for signs of domestic pressure, was expected to slow to 5.5% but remained relatively unchanged at 5.9% after a 6% reading the previous month. This is significant and is a key reason why a June rate cut might be off the table.

UK inflation is narrowing in scope, with over 40% of items in the CPI basket now under the 2% target. However, there is still a way to go for the BoE, with over 12% of items still rising at a pace of 6-8%. Moreover, because the latest figures exceeded forecasts, particularly in services inflation, this is a major setback for those advocating a BoE rate cut in June, and it explains why the pound has appreciated this morning.

The USD index is building on gains from the previous session, following one of its worst weeks of the year so far. Last week, the dollar weakened against pro-cyclical currencies—those that tend to perform better amid hopes of improving global economic growth. These hopes have risen due to increasing expectations of interest rate cuts aimed at supporting economies.

However, the global risk rally has lost some momentum as Atlanta Fed President Raphael Bostic indicated that it will take time for the central bank to be confident that inflation will return to 2%, reiterating that only one rate cut will be necessary this year. In the short term, we believe a low volatility environment should offer the dollar some reprieve, given its high yield appeal in the carry trade strategy. But as we move into the second half of the year, the dollar is likely to weaken amid a moderating US growth outlook and a continuing disinflation trend. Historically, the dollar's performance after the Fed's last rate hike places it in the 90th percentile of its historical performances, suggesting that its current strength may diminish if history repeats itself.

With little on the US economic data calendar this week to influence currency movements in the near term, attention remains on a series of Fed speakers for clues on the US rate outlook and the timing of a potential easing cycle.

Unlike in the US, UK inflation in recent quarters has fallen short of the central bank's expectations and is likely to return to target in the next month or two. The headline CPI for Wednesday is forecast to drop from 3.2% to 2.1%, which could increase the likelihood of a Bank of England (BoE) interest rate cut as early as June. However, the BoE is more focused on services inflation, prioritizing it in monetary policy decisions due to recent volatility in wage figures. If services inflation exceeds expectations, the chances of a June rate cut will likely decrease, potentially pushing the pound towards $1.28.

The EUR retreated against the USD at the start of a quiet week with a sparse data calendar. EUR/USD traded within a narrow 30-pip range, slightly below the daily open of $1.0867. Daily realized volatility fell to 3.6% on an annualized basis, significantly lower than the one-month level of 5.6%. European bonds and stocks remained steady, awaiting new catalysts for the monetary policy outlook.

The primary factor influencing market pricing and the GBP's short-term outlook is the UK inflation report due on Wednesday. Consensus expectations suggest that the headline CPI will decrease from 3.2% to just above the Bank of England’s (BoE) 2% target. This could limit GBP’s upward momentum if traders focus on weakening rate differentials rather than the improving growth outlook.

The report’s outcome could either trigger the beginning of an interest rate-cutting cycle at the BoE next month, which would be negative for GBP, or signal to policymakers that the battle against inflation is not over, which would be positive for GBP.

Notably, the services component of the inflation basket is likely to generate the biggest market reaction, as the BoE has emphasized its focus on this area. Deputy Governor Ben Broadbent highlighted on May 9th that he will scrutinize services inflation more closely than wages in the short term.

The GBP/EUR exchange rate has trended higher in recent days, comfortably returning to the middle of the 2024 range. Although the pair is still down for May, last week's recovery has improved the technical outlook, and a retest of 1.17 could occur in the coming days. However, significant movement is unlikely before Wednesday’s UK inflation data release. It is possible that GBP/EUR may slip earlier in the week as investors reduce exposure ahead of the report.

Against the USD, GBP recorded its second-best weekly advance of 2024, hovering at six-week highs around GBP/USD 1.27. Signs of cooling US inflation and a weakening US economy have increased the likelihood of Federal Reserve rate cuts, exerting pressure on the USD.

The USD index rebounded from 5-week lows yesterday, buoyed by data showing a 0.9% increase in US import prices last month. This data tempered some of the optimism about US disinflation and potential Federal Reserve (Fed) rate cuts that had emerged earlier in the week. Despite this rebound, following a slightly softer CPI report and signs of a cooling US economy and job market, the USD is on track for a weekly loss and is experiencing its worst month of 2024.

The slowdown in consumer prices led markets to anticipate that the Fed might cut rates twice this year, with the first cut possibly coming as early as September. However, concerns are resurfacing as import and export prices rose more than expected, alongside a surprise increase in producer prices earlier in the week. This suggests that inflation is moderating above the Fed’s 2% target, which could delay plans for rate cuts and potentially keep the USD stronger for a longer period.

The recent aggressive sell-off in the USD highlights our ongoing theory of its asymmetric reaction to incoming data—falling more on data misses than rising on data beats. However, we believe the market overreacted this week, as reflected in the dollar’s modest bounce-back yesterday.