Sterling Rises on Strong Wage Growth, but Upside May Be Limited

Sterling is trading near a two-month high against the US dollar after UK jobs data revealed a sharper-than-expected rise in wage growth, reaching an eight-month high. This has pushed 10-year gilt yields higher as markets reassess the Bank of England’s (BoE) ability to contain inflationary pressures.

The three-month average weekly earnings y/y increased to 6.0% in December, surpassing expectations of 5.9% and up from 5.6% in November. Pay growth, excluding bonuses, climbed for a third consecutive month, driven largely by the private sector (6.2%). The BoE closely monitors this metric, as persistent wage inflation contributes to sticky services inflation. After adjusting for inflation, real wages also saw a slight increase. Meanwhile, the unemployment rate remained at 4.4%, defying expectations of a rise to 4.5%, while job vacancies continued to decline at a slower pace. These figures are likely to reinforce the BoE’s cautious stance as it weighs persistent wage pressures against the UK’s sluggish economic growth and ongoing job market adjustments.

As a result, expectations for BoE rate cuts have been scaled back slightly. Against the euro, sterling has broken out of a narrow trading range and may look to extend gains beyond €1.21, particularly given Europe’s political uncertainties. However, against the US dollar, sterling appears overbought, and a correction may be likely. While the 100-day moving average at $1.2666 could be tested in the near term, further upside may be limited.

Euro's Rally Faces Resistance Amid Political and Economic Uncertainty

After posting its second-best week of the year, the euro’s rebound from near $1.01 to $1.05 against the US dollar appears to be losing steam. While EUR/USD has broken out of its descending trend channel, in place since last October, technical indicators suggest it is now overbought. Additionally, European equities started the week cautiously as tensions between the US and Europe over Ukraine and tariffs escalated.

European leaders convened an emergency meeting in Paris on Monday to discuss security concerns, raising fears of increased government borrowing to fund military expenditures. This drove Germany’s 10-year bond yield to a one-month high of 2.5%, as higher spending could fuel inflation and push yields higher. Meanwhile, US-Russia negotiations on Ukraine are set to begin on Tuesday, with a successful outcome potentially driving oil prices lower, which could provide some support to the euro. However, while ceasefire prospects have bolstered risk appetite and the euro, concerns over US isolationism and European security risks remain a headwind for the currency.

On the monetary policy front, the European Central Bank is expected to cut interest rates by 25 basis points at each of the next three meetings, with the deposit rate potentially falling below 2% by 2026. While this would typically weigh on the euro, rising US inflation could shift the real rate differential in favour of further EUR/USD gains.

However, given the uncertain macroeconomic landscape—alongside geopolitical and tariff-related risks—EUR/USD's upside potential may be capped for now. A stronger domestic outlook and weaker US economic data would be needed to push the pair toward $1.06. Investors will closely watch Germany’s ZEW sentiment surveys today, with expectations for the index to rise to a six-month high.

Tariff Delays and Peace Talks Lift Markets, Weigh on Dollar

The market continues to feel the positive effects of the recent postponement of tariffs on Mexico and Canada. Adding to the risk-on sentiment, reports surfaced that President Trump is actively working on a peace deal between Ukrainian President Zelensky and Russian President Putin. This optimism drove oil prices lower and overshadowed shifts in Federal Reserve expectations, putting additional pressure on the US dollar.

Meanwhile, last week’s inflation data had a mixed impact. The higher-than-expected CPI print was offset by a weaker PPI figure, leaving inflation as a net-neutral factor for markets. However, the sharply disappointing retail sales report just before the weekend further weakened the dollar, while equities extended their rally. As a result, the probability of a Fed rate hike this year fell from 9% to 3%. Market volatility remains high, with uncertainty persisting on both inflation and trade policy fronts.

British Pound Rides Risk Rally but Faces Key Data Tests

The British pound strengthened against safe-haven currencies last week, benefiting from easing trade tensions and renewed hopes for a Ukraine ceasefire, which sent oil prices tumbling. GBP/USD surged from around $1.23 to over $1.26, while GBP/JPY climbed more than 2% in a week. However, GBP/EUR remained relatively stable as geopolitical tailwinds also supported the euro.

Looking ahead, the impact of a potential Ukraine ceasefire could be mixed—if the deal raises security concerns for Europe, the war premium on the euro may stay low, capping further FX gains. Meanwhile, growing market focus on trade risks highlights the UK’s relative resilience to direct tariffs compared to the Eurozone, helping GBP/EUR hold above €1.20. Additionally, rate differentials continue to favour the pound, with last week’s UK GDP surprise leading traders to scale back expectations for BoE rate cuts.

Key economic data this week will test the pound’s strength. Employment figures on Tuesday, flash PMIs and retail sales on Friday, and inflation data on Wednesday will be closely watched. In particular, services inflation, which has remained stubbornly above 4% for nearly three years, is expected to jump back above 5%. The key question for UK rate markets remains whether to price in two or three BoE rate cuts for the rest of the year.

Euro Finds Respite Amid Trade and Geopolitical Shifts

The euro defied expectations last week, rallying against the dollar as geopolitical and trade developments turned unexpectedly supportive. EUR/USD briefly touched $1.05—only the second time this year—marking its strongest weekly performance in three weeks. Hopes for a peace treaty between Russia and Ukraine gained traction, partly due to President Trump’s diplomatic involvement. Meanwhile, fears of imminent US tariffs on European cars subsided, with reports suggesting a delay until at least April 2nd, aligning with the expected completion of a Department of Commerce review on reciprocal tariffs.

However, risks remain for the eurozone. President Trump has taken aim at value-added taxes (VAT), arguing they function as disguised tariffs that disadvantage US businesses. Given that VAT is a critical revenue source for the EU, the scope for negotiation is minimal, potentially setting the stage for renewed trade tensions.

While our expectation of a modest euro rebound has played out, supported by rising real rate differentials and a priced-in Fed pause, broader macro uncertainties and tariff risks could cap further gains. Without stronger domestic catalysts, EUR/USD may struggle to break past $1.06 in the near term.

Tariff Fatigue and Hidden PPI Optimism

Investors experienced a volatile trading session yesterday, with inflation data and trade-related headlines driving price fluctuations across asset classes. The US President has ordered a review of reciprocal tariffs, aiming to address trade imbalances through country-specific levies. The final outcome is expected by 1 April, raising concerns about potential retaliatory measures and prolonged trade uncertainty.

Meanwhile, January’s Producer Price Index (PPI) came in higher than expected, briefly stoking inflation fears. However, key components feeding into the Federal Reserve’s preferred Personal Consumption Expenditures (PCE) index showed declines in areas such as healthcare services and airfares, shifting focus to the upcoming PCE release on 28 February. US government bond yields fell across the curve by nearly the same magnitude they had risen following the Consumer Price Index (CPI) surprise. Equities moved higher in response.

The US dollar continued its decline for a third consecutive day, weakening against all G10 currencies on Thursday. This reflects two key dynamics: (1) investors remain highly sensitive to inflation data as they gauge the trajectory of price pressures, and (2) foreign exchange markets are displaying signs of fatigue regarding tariff-related news.

While Trump’s trade rhetoric and tariff policies will remain major market drivers, investors are becoming more discerning in their reactions. Given Trump’s history of shifting positions on key trade issues, markets are now responding with a more measured approach rather than overreacting to every development.

Euro Gains 1.3% This Week

The euro has strengthened for three consecutive days against the US dollar, breaking above $1.04 and marking a new high for February, solidifying its breakout above the 20-day moving average. After several failed attempts to sustain gains earlier in the week, the pair appears to have made a decisive move, shifting the short-term bias to the upside.

The evolving tariff narrative continues to keep currency traders engaged. However, the delayed implementation of tariffs has allowed the euro to advance this week, a move further boosted by constructive developments in the Russia-Ukraine conflict, despite European and Ukrainian officials reportedly being excluded from negotiations thus far. Nonetheless, bullish momentum for the euro may start to wane if the pair fails to close the week above $1.0450. The outlook for the single currency remains fragile due to weak Eurozone economic performance and firm expectations that the European Central Bank (ECB) will extend its monetary easing cycle, with inflationary pressures expected to sustainably return to the 2% target by year-end.

From a technical standpoint, $1.05 is emerging as the next key resistance level. On the downside, the 20- and 50-day moving averages may now serve as support, but if the pair falls back below $1.0350, the risk of a steeper decline increases, particularly given the lingering negative drivers weighing on the euro.

Digging into the GDP Figures

Sterling’s positive reaction to the UK’s stronger-than-expected GDP figures was short-lived, as the bigger takeaway is that the economy remains stuck in a low-growth trap—an ongoing challenge for both the Treasury and the Bank of England (BoE). That said, GBP/USD has held above its 50-day moving average and remained above $1.25, supported by US dollar weakness amid positive tariff and geopolitical news.

The UK ranked mid-table for growth among G7 nations at the end of last year, outperforming its European counterparts and avoiding a technical recession. Growth was driven by strength in the services and construction sectors, although the manufacturing sector remains in recession. However, a closer look at the data reveals that the primary driver behind the 0.1% expansion in the final quarter of 2024 was a surge in inventories, with businesses stockpiling raw materials and components. These figures tend to be highly volatile, while more telling indicators such as household consumption, exports, and business investment were all flat or negative. Notably, business investment contracted by 3.2%, and the production sector shrank for a fifth consecutive period—both indicators of underlying weakness that could dampen hiring and wage growth. This could also reinforce the disinflationary trend, which may keep the BoE on its easing path—providing a tailwind for gilts but a headwind for sterling.

The BoE expects economic weakness to persist into 2025 and recently halved its growth forecast for this year to 0.7%. Dovish members of the Monetary Policy Committee are increasingly concerned that a slowdown necessitates more substantial rate cuts. Next week’s UK inflation report will offer further insights. While the January figures may not reflect it, upside risks to inflation are growing in the coming months due to the sharp rally in natural gas prices and adjustments to UK energy and water bills.

Dollar Decline Surprises the Market, Not Us

The US dollar weakened yesterday against the euro, despite US inflation coming in hotter than expected and Treasury yields rising across the curve. Equities ended the day in negative territory but managed to recover more than half of their intra-day losses. Consumer prices exceeded expectations across multiple measures, with the monthly figure reaching 0.5% and the core reading at 0.4%, both surpassing forecasts of 0.3%. Headline inflation has now returned to 3% for the first time since June 2024. In response, Federal Reserve Chair Jerome Powell acknowledged that the latest data indicated further work was needed to bring inflation under control.

Markets reacted to the inflation surprise and Powell’s comments by scaling back expectations for interest rate cuts, now anticipating just one reduction this year. However, the dollar failed to capitalise on this shift, confirming its asymmetric reaction function. Instead, geopolitical optimism took precedence. Reports surfaced suggesting that President Trump may be actively working on a peace deal with Ukrainian President Zelensky and Russian President Putin.

This development bolstered risk sentiment, lowered oil prices, and overshadowed the Fed repricing, putting downward pressure on the US dollar. The market reaction aligns with our view that, for now, positive geopolitical developments have a greater influence on foreign exchange markets than concerns about a delay in Fed rate cuts. If this trend persists, the dollar could remain vulnerable despite resilient US economic data.

Euro Strengthens Amid External Factors

The euro appreciated, defying the backdrop of rising US bond yields and revised Fed rate expectations. While US inflation exceeded forecasts—pushing Treasury yields higher and leading investors to price in just one Fed rate cut this year—the dollar weakened due to optimistic geopolitical developments. Reports that President Trump may be negotiating a peace deal with Ukrainian President Zelensky and Russian President Putin shifted market sentiment, reinforcing our view that geopolitical optimism currently outweighs Fed-related concerns.

In Europe, European Central Bank (ECB) policymaker Joachim Nagel further supported the euro by advocating a cautious approach to monetary easing. Speaking in London, the Bundesbank President dismissed the idea of targeting a theoretical “neutral” interest rate, instead urging caution in the ECB’s rate-cutting trajectory. This aligns with our perspective that, while the ECB is set to lower interest rates, expectations of aggressive easing may be overstated. With markets reassessing Fed rate cut expectations and the ECB signalling a measured approach, euro sentiment remains well-supported.

For the time being, investors appear more focused on geopolitical tailwinds than on narrowing nominal interest rate differentials. It is also worth noting that US market-based inflation expectations have been rising for some time, with certain maturities (such as the five-year tenor) reaching their highest levels in years. This theoretically reduces the real rate differential between the US and Europe.

Sterling Rises Above $1.25 Following Strong UK GDP Data

Sterling initially fell sharply against the US dollar following the release of the US inflation report but swiftly recovered as risk appetite improved amid encouraging geopolitical news regarding a potential resolution to the war in Ukraine. As a result, the euro and central and eastern European currencies outperformed, causing GBP/EUR to lose its grip on the €1.20 level. Safe-haven currencies such as the Japanese yen tumbled, with GBP/JPY now up nearly 3% week-to-date.

Meanwhile, GBP/USD has surpassed its 50-day moving average at $1.2475. A daily close above this level would increase the likelihood of a move towards the $1.26-$1.27 range. However, despite stretched US dollar positioning and valuation, there remain numerous dollar-positive drivers that could limit sterling’s upside. Indeed, foreign exchange options traders are taking precautions against a potential decline in the pound. GBP/USD one-month risk reversals are two standard deviations lower than their one-year average, indicating that traders are significantly more concerned about sterling weakening over the next month than they have been on average over the past year. Meanwhile, one-month implied volatility—reflecting the market’s expectations for price fluctuations—has stabilised after hitting two-year highs in January but remains within the 80th percentile of observations over the past year.

On the macroeconomic front, UK GDP data released this morning exceeded expectations, providing a further boost to sterling. Preliminary fourth-quarter GDP unexpectedly expanded by 0.1% on a quarterly basis, defying expectations of a 0.1% contraction. Additionally, December’s industrial production data came in slightly better than anticipated, contracting by 1.9% year-on-year compared with the forecasted -2.1%. These figures highlight the resilience of the UK economy, which should support the pound in the short term as traders reassess expectations for the Bank of England’s interest rate trajectory. Traders now anticipate 55 basis points of rate cuts, down from over 60 basis points priced in at yesterday’s close.

However, we remain mindful that the UK is not immune to global economic headwinds, particularly given the slowdown in trade due to tariffs. Furthermore, while the UK maintains a balanced goods trade relationship with the US, it runs a significant trade surplus in services, which could be vulnerable to tariffs extending beyond goods trade—although such measures are typically more challenging to implement.