UK Economy Faces Stagflation and Falling Sterling Amid Economic Struggles

The UK economy is entering a challenging period of low growth and high inflation, a combination often referred to as stagflation, which poses significant risks for the British Pound (Sterling).

Sterling weakened against the Euro and the Dollar following data from the Office for National Statistics (ONS) revealing that the UK economy expanded by just 0.1% month-on-month in November, falling short of the expected 0.2% growth. This brought the annual growth rate down to 1.0%.

The Pound to Euro exchange rate dropped to 1.1864 in response, erasing more than half of the prior day's rally, which had been driven by lower-than-expected inflation figures in both the UK and the U.S. The Pound to Dollar exchange rate also declined, trading at 1.2206, down 0.20% on the day, with downward momentum firmly in place.

This economic stagnation is unwelcome news for Chancellor Rachel Reeves, who is relying on growth to bolster government revenues and fund increased spending over the next four years. However, market concerns about the UK’s debt sustainability in the absence of economic growth have triggered a selloff in UK bonds and Sterling.

While the UK was the fastest-growing G7 economy in the first half of the year, it has since faltered. According to the ONS, the economy showed no growth in the three months to November 2024 compared to the previous three months. Modest positive contributions from the services sector (+0.1%) and construction (+0.3%) in November were offset by a 0.4% decline in production output, following a 0.6% drop in October.

Prime Minister Keir Starmer and Chancellor Reeves have emphasized the need for "tough decisions," including tax increases, which have strained businesses and households. The subsequent budget measures have led to reduced business spending, higher prices, and job cuts. The resulting slowdown in economic activity threatens to lower tax revenues, potentially forcing further tax hikes and spending cuts, exacerbating already low consumer and business confidence.

With these challenges looming, the outlook for the British Pound appears equally bleak, as markets grapple with the economic and fiscal uncertainty facing the UK.

Inflation Data Sparks Optimism in Financial Markets

Financial markets have reacted sharply to inflation concerns, with even minor data surprises fuelling bullish sentiment in equities and bonds. The US dollar declined for the third consecutive day as investors embraced two weaker-than-expected inflation reports this week—core CPI and core PPI.

The recent dip has offered investors an opportunity to take profits after weeks of upward pressure on the Greenback. The broader upward trend in the US Dollar Index (DXY) remains intact, provided it stays above the 108.60 level. Meanwhile, the US 10-year Treasury yield is on track to record its second-largest daily decline of the year.

Despite these developments, inflation trends remain a mixed picture. Broad measures of inflation are still edging higher as reflationary pressures re-emerge. Encouragingly, declines in core, shelter, and services inflation provide some relief, but sustained improvement is crucial. Consistent downward trends in inflation over the first quarter of the year—similar to this week’s data—would bolster confidence in the Federal Reserve’s policy trajectory.

Investors, however, have little time to focus solely on inflation data as attention shifts to key economic releases scheduled for today. Reports on retail sales, initial jobless claims, the Philly Fed Manufacturing Index, and the NAHB Housing Index are set to provide further insights.

Retail sales are anticipated to show strong performance, driven by robust holiday shopping and increased car sales, as consumers likely frontloaded spending ahead of anticipated tariff hikes under the Trump administration. These factors should help stabilize market sentiment and limit downward pressures for the remainder of the week.

Euro Struggles Amid Weak Economic Outlook Despite US Data

The euro was poised for a third consecutive day of gains against the US dollar, buoyed by weaker-than-expected US data. However, bearish sentiment during the US session pushed EUR/USD lower, falling from $1.0350 to below the $1.03 level. Unlike the pound, yen, or yuan, which have managed to leverage softer US economic indicators, the euro continues to face significant challenges, largely due to Europe’s fragile economic growth outlook.

Eurozone inflation ticked higher in December but did little to influence the European Central Bank’s (ECB) current policy trajectory. Both ECB Chief Economist Philip Lane and Vice President Luis de Guindos reiterated the need for further rate cuts. With the deposit rate currently at 3% and the neutral rate estimated between 2% and 2.5%, policymakers still have room to lower rates as necessary.

The broader macroeconomic landscape offers little optimism. While Eurozone industrial production increased for the second month in a row with a modest 0.2% rise in November, this growth is insufficient to counter the region’s economic stagnation. Germany, the Eurozone’s largest economy, continues to weigh heavily on the region’s prospects, having contracted for a second consecutive year in 2024—a first since 2003. With the 2025 outlook equally bleak, concerns about Europe’s economic trajectory persist, keeping the euro under pressure.

Pound Sterling Rises as UK Inflation Falls Below Expectations

In a surprising turn of events in early 2025, the British Pound has strengthened despite UK inflation coming in weaker than expected. Traditionally, softer inflation figures tend to weaken a currency, but recent data has bucked this trend.

The Pound to Euro exchange rate climbed from 1.1835 to 1.1868 following the Office for National Statistics' report that UK CPI inflation rose 2.5% in the 12 months to December 2024. This figure marked a decrease from 2.6% in November and fell short of the anticipated 2.7% rise. Similarly, the Pound to Dollar exchange rate increased to 1.2240 from 1.2184, coinciding with a decline in UK bond yields. The ten-year UK gilt yield dropped to 4.813% from 4.90%.

Monthly inflation rose by 0.3% in December, below the expected 0.4%. Core inflation slowed to 3.2% year-on-year, down from 3.5% and missing the forecast of 3.4%. Service inflation, closely monitored by the Bank of England, showed a notable decrease from 5.0% to 4.4%.

A key market dynamic has emerged in 2025: the Pound now reacts inversely to UK bond yields. Previously, rising yields supported the currency, but heightened concerns over the UK's debt and economic outlook have shifted the narrative. This shift was evident after Chancellor Rachel Reeves' recent budget, which has been criticised for stifling growth.

Today's lower-than-expected inflation data eased fears of further yield increases, leading to the 'yields down, Pound up' reaction. This development is especially significant given the sharp rise in UK bond yields earlier in the year, which had signalled declining confidence in the country's financial health.

The data also paves the way for a potential interest rate cut by the Bank of England next month, a move that could further reduce bond yields. For now, the currency's recent gains offer some relief amidst broader concerns about the UK's economic trajectory.

US Dollar Struggles Amid Mixed Data and Policy Uncertainty

The US dollar struggled to sustain its weekly gains, slipping approximately 0.8% from its peak on Monday. Recent reports indicate that the Trump administration may adopt a more cautious and gradual approach to implementing tariffs. While uncertainty remains, this aligns with earlier assessments made during July’s presidential preview. With Trump’s tariff strategy and the Federal Reserve’s (Fed) pause largely priced in, the dollar appears to be showing signs of fatigue.

Further downward pressure came from weaker-than-expected producer price data released yesterday. December’s producer prices rose 0.2%, with an annual increase of 3.3%—the highest since February 2023 but slightly below the forecast of 3.4%. Core producer prices were even more surprising, rising 3.5% year-on-year against an expected 3.8%. While these figures raise questions about the pace of inflation, investors are looking ahead to the upcoming Consumer Price Index (CPI) report, which will play a critical role in shaping expectations for inflation and the Fed’s policy outlook. Notably, the dollar reacted more strongly to reports of a tempered tariff strategy than to the slight PPI miss.

The National Federation of Independent Business (NFIB) report, which showed rising optimism among small business owners, had limited impact on the dollar. The Small Business Optimism Index rose for the fourth consecutive month in December, reaching its highest level since October 2018. Optimism is fuelled by expectations of pro-growth policies, including deregulation and favourable tax reforms, with nearly half of respondents anticipating better economic conditions—the highest percentage since 1983.

However, caution is warranted when interpreting this optimism. Small business owners, often leaning Republican, have historically shown heightened optimism during Trump’s presidency. The spike in confidence linked to the political climate was similarly observed after both of Trump’s elections. The second half of the year will be pivotal in determining whether these expectations translate into tangible economic growth. Until clearer signals emerge, the dollar may continue to face challenges.

Euro Stagnates Amid US Developments, While China's Trade Surplus Sets Records

The euro remains tethered to developments in the United States, struggling to generate momentum independently. This dynamic has allowed EUR/USD to climb back above the $1.03 mark, aided by weaker-than-expected US PPI data and disappointing tariff news that dampened dollar strength. With no significant economic data releases from the Eurozone or Germany this week, the euro is unlikely to break free from this pattern in the near term.

However, the spotlight shifts to China, which closed 2024 on a high note with a record trade surplus in December. This milestone underscores China’s influential role in global trade but raises questions about its long-term sustainability amid increasing economic complexity and criticism under Donald Trump’s administration. Recent years have seen heavy scrutiny of China’s industrial and subsidy policies. In response, the nation has emphasized openness, exemplified by initiatives like the China International Import Expo, aiming to counter accusations of economic nationalism.

China’s approach aligns with its broader strategy to position itself as a champion of globalization in the face of rising protectionism elsewhere. By expanding imports and adopting a narrative critical of restrictive trade practices, China seeks to shift global perceptions. This positioning could appeal to developing nations, especially as Western economies, led by the United States, continue to embrace protectionist policies.

Sterling Under Pressure: GBP Faces Persistent Declines Amid Dollar Strength and Domestic Challenges

The British pound has recorded five consecutive daily declines against the US dollar. From October 2024 to yesterday, GBP/USD has managed only 29 positive days and lost nearly 10% of its value. The primary driver behind this trend is a broadly stronger US dollar. However, renewed negative structural factors, including rising UK long bond yields, have further exacerbated the pound's downtrend.

Looking ahead, the outlook for sterling remains challenging. Traders are focusing on the psychological $1.20 mark as a key downside target. While the relative strength index indicates oversold conditions that could trigger a short-term rebound, a sustained recovery hinges on a reversal of the positive US dollar narrative—a scenario that appears unlikely given the steady flow of positive news from the US. Domestically, any meaningful recovery depends on improvements in the UK economy and an effective fiscal response to escalating debt-repayment costs.

A key event this week is the UK inflation report, set for release on Wednesday. Unfortunately for the pound, the outcome might prove unfavourable regardless of the data. Persistently high inflation could delay Bank of England (BoE) rate cuts, adding pressure to the strained gilts market and widening the gap between yields and sterling. On the other hand, a softer inflation reading could ease bond-market stress but also lower short-dated GBP interest rates as markets price in additional BoE easing, which might weigh on the pound further.

Rachel Reeves is set to deliver a statement on her recent trip to China, but opposition parties are expected to seize the opportunity to question her about ongoing market anxieties surrounding the surging cost of UK debt and the pound’s continued decline.

The Chancellor’s notable absence in recent days has fuelled speculation, with official communications limited to Treasury statements and a single appearance by her deputy, Darren Jones. Despite declining economic growth and turmoil in UK bonds and the pound, the government has reiterated its commitment to maintaining its current spending and taxation plans.

The economic backdrop remains challenging. Borrowing costs have soared, and the pound has weakened following evidence that the economy has stagnated under Labour leadership. Reeves had pledged to stimulate growth to support significant public spending increases in the coming years. However, without economic expansion, the government may find it increasingly difficult to manage its mounting debt.

Investors are keen to learn whether the Chancellor has been contemplating new strategies to address rising borrowing costs and will introduce policies to restore confidence in the UK economy. In the near term, the path of least resistance for sterling appears to be downward.

Investors Reassess Federal Reserve Policy Outlook Amid Rising Dollar and Market Tensions

Investors have adjusted their expectations for Federal Reserve policy in the coming year. Fed funds futures now show a significantly higher probability that the Fed will pause its easing cycle at upcoming meetings.

This recalibration reflects a growing consensus that current economic conditions may not justify further rate cuts in the near term. As 2025 begins, markets are pricing in only a single rate cut for the year. This sentiment has bolstered the US dollar, which has reached its highest level since November 2022. The trend forms part of a mini-cycle that began in October, marked by the bottoming of yields, stocks, and the dollar.

Despite these developments, equities are facing headwinds as yields and the dollar continue to climb. The S&P 500 has dropped about 5% since its mid-December peak, while the VIX has risen from approximately 14 to 19 points during the same period.

Market attention now turns to key US economic indicators this week, including the NFIB Business Optimism Index and the Producer Price Index (PPI). The PPI, expected to increase from 3% to 3.4%, could reinforce the argument for the Federal Reserve to maintain its current rate stance through the first half of 2025.

Germany's Dual Dependency Dilemma: Balancing Between the US and China

Germany has long thrived as a sovereign force in the global market, driven by its export-led economy. However, beneath this success lies a complex web of dependencies that influence the nation’s strategic decisions. Chief among these is Germany's reliance on two major economic powers: the United States and China. Navigating this dual dependency presents a significant challenge as Germany seeks to balance the interests of these influential partners.

As global geopolitical and economic dynamics evolve, Germany faces the task of leveraging its trade relationships with both the US and China while diversifying its partnerships to reduce vulnerabilities. This "dual dependency dilemma" is further complicated by a lack of consensus within the German government and public, making the path forward increasingly fraught.

Market sentiment reflects these challenges. The euro recently dipped below the $1.02 mark against the dollar, signalling waning optimism. Meanwhile, implied volatility for the euro on the three-month tenor surged to 9.4%, the highest level since March 2023, underscoring heightened uncertainty in the economic outlook.

US Jobs Surge Shakes Markets as Dollar Climbs and Yields Soar

A robust US jobs report sent ripples through financial markets on Friday, propelling the US dollar to its highest level since November 2022 and triggering a surge in yields across the curve. The report revealed an above-consensus increase of 256k jobs, accompanied by a drop in the unemployment rate to 4.1%, with only minor downward revisions to the prior two months. While the labour market strength was anticipated, the scale of the surge exceeded expectations, as forecasts had predicted a 190k increase (compared to a 160k consensus).

This development signals to the Federal Reserve (Fed) that rate cuts are unlikely in the first half of the year. Investors have adjusted their expectations, now anticipating policy easing to begin in October. The resilience of the US labour market has been remarkable, particularly given its continued strength following the 2022 yield curve inversion—a rare phenomenon. This anomaly may partly explain the sharp rise in yields, despite the Fed initiating its easing cycle.

British Pound Slides Amid Stagflation Worries and Rising Yields

The British pound extended its decline on Monday, with GBP/USD falling below $1.22 to its lowest level since November 2023, while GBP/EUR dropped below €1.19 for the first time in over two months. Mounting concerns about stagflation in the UK are weighing on the currency, as inflation—particularly in the services sector—remains stubbornly high amid signs of economic weakness.

The UK’s two-year inflation breakeven rate has surged by 70 basis points since the autumn 2023 budget, which unveiled ambitious borrowing and spending plans. While UK gilt yields have moved in tandem with US Treasury yields, the pound has weakened as the US dollar strengthened. This reflects the mounting pressure on the UK government as gilt yields climb higher. Over the weekend, UK Chancellor Rachel Reeves reaffirmed that the fiscal rules laid out in October’s budget are non-negotiable, encouraging traders to test key support levels for sterling.

This week, markets will closely watch the UK’s December inflation data, with Wednesday’s report expected to show headline consumer prices rising 2.6%, matching the previous figure. Additionally, GDP and retail sales data will be scrutinised for signs of a recovery in consumer spending, which could provide some much-needed relief for the pound.

EUR/USD Slides as USD Strength and European Risks Weigh on the Euro

EUR/USD continues its downward trend, trading in negative territory for a fifth straight day and approaching the $1.02 level during the early European session. The pair’s decline is largely driven by broad-based US dollar strength following a robust US jobs report, while weak domestic factors—both cyclical and political—add further pressure on the euro.

Similar to the UK, Europe faces stagflation risks. December inflation data showed an uptick, mainly due to fuel price base effects, alongside resilient services sector numbers. While this could suggest caution for the European Central Bank in easing policy, the Eurozone's bleak growth outlook complicates the situation. Challenges include China’s economic struggles and potential trade tensions with the US, creating a mix of stagnating growth and persistent inflationary pressures that undermine the euro.

Political uncertainty within Europe further exacerbates the euro’s struggles, highlighting the need for fiscal interventions, particularly in Germany, to rejuvenate the sluggish economy.

With limited high-impact European data scheduled for the week, EUR/USD is likely to remain influenced by external factors. The continued economic outperformance of the US does not bode well for the euro in the near term.