Tumultuous Day for the British Pound and UK Markets

The British pound and UK equity benchmarks experienced sharp declines yesterday, with bond prices tumbling and yields surging. The 10-year gilt yields reached their highest level since the 2008 financial crisis, while 30-year yields climbed to levels not seen since 1998.

The pound fell by over 1%, with GBP/USD hitting its lowest level in more than a year. Breaking through its Bollinger band and last year’s lows, the pair is now approaching the October 2023 low of $1.2037. Sterling faced significant volatility across G10 currencies, with daily declines exceeding two standard deviations compared to the average performances over the past five years. Even GBP/EUR, which had remained stable above €1.20 for weeks, has dropped closer to €1.19.

This turmoil was largely triggered by weak demand in recent UK government debt auctions. The resulting surge in long-term borrowing costs pushed bond yields to multi-decade highs. While higher yields could theoretically support the pound, persistent economic concerns—characterized by weak growth, sticky inflation, and fears of stagflation—outweighed any potential benefits.

These events signal a broader reassessment of the UK’s economic prospects under the Labour government. Optimism about political stability has given way to worries over rising taxes, public spending, stagnating growth, and inflation. The market's reaction mirrored the turmoil of the 2022 Liz Truss budget, although the current situation is less severe. However, the UK’s persistent current and capital account deficits leave the pound exposed to foreign investor sentiment.

Adding to the pressure, the pound seems disconnected from the expected monetary policy path. Divergences between GBP/USD and UK-US yield spreads highlight this growing gap. The Bank of England’s policy trajectory compounds the challenge; while markets expect minimal rate cuts, stagflation fears have muted any potential boost to sterling. Conversely, stronger signals of rate cuts could weigh further on the currency.

For the pound to stage a recovery, a combination of stronger economic data and improved confidence in fiscal policy will be essential. Until then, sterling remains vulnerable to both domestic and international pressures.

US Dollar Gains Momentum Amid Economic Optimism and Fed Hawkishness

The US dollar has regained strength, buoyed by encouraging economic data and hawkish minutes from the Federal Reserve's December meeting. These developments have validated the Fed’s pivot to a more aggressive stance on rate cuts, driving the dollar's rebound against major currencies. Long-term Treasury yields are also nearing 5%, reflecting this optimism. However, much of the positive sentiment appears to be already factored into the dollar and bond markets.

Attention now shifts to Friday’s monthly jobs report, a key data release ahead of the Fed’s next monetary policy decision. This report will provide the final labour market update before the Fed enters its pre-meeting blackout period. Expectations are for US payrolls to have increased by 163,000, with the unemployment rate remaining steady at 4.2% and average hourly earnings rising 0.3% month-over-month. The chart below illustrates how closely inflation and labour market data influence market expectations for the Fed's policy trajectory. The Fed funds rate pricing has closely tracked surprises in inflation and employment metrics, highlighting the ongoing dominance of the Fed’s dual mandate in shaping market sentiment.

October marked a turning point for this proxy indicator of the Fed’s mandate and the dollar's performance. While the index has plateaued since November, the dollar's rally has continued, driven by two key factors: the "Trump trade" and growing political risks outside the US. Together, these dynamics have reinforced the Greenback’s resilience in the face of evolving market conditions.

EUR/USD Struggles Amid Diverging Economic Trends

The EUR/USD pair experienced a turbulent session yesterday and is trading near $1.03 this morning. The US dollar continues to gain strength this week, supported by strong economic data, including robust employment numbers and improved consumer confidence. These indicators have reinforced expectations of a hawkish Federal Reserve, boosting the greenback.

In contrast, the Euro faces headwinds from weak economic data in the Eurozone. German factory orders unexpectedly declined in November, signaling deeper economic challenges. Additionally, German retail sales contracted during the same period, raising concerns about the health of the Eurozone’s largest economy. These disappointing figures, combined with rising energy prices and the ongoing energy crisis, have weighed heavily on investor sentiment toward the Euro.

The outlook for EUR/USD remains uncertain. If US economic data continues to surprise on the upside and the Fed maintains its hawkish stance, the Euro may face further pressure. However, signs of weakness in the US economy or a shift toward a more dovish Fed could offer some relief to the common currency.

Euro Struggles Amid Rising Inflation Concerns and Weak Economic Data

The euro failed to sustain its two-day winning streak that began on Friday, falling back below the $1.04 mark. Stronger U.S. macroeconomic data has heightened inflation concerns, driving longer-term Treasury yields higher and exerting downward pressure on the euro. In Europe, price pressures have started to build as well, tempering expectations of rate cuts by the European Central Bank (ECB). However, the weak growth outlook underscores looming stagflationary risks, challenging euro bulls as selling pressure persists.

Inflation in Europe rose for the fourth consecutive month in December, reaching a five-month high of 2.4%. Although the increase was stronger than anticipated, base effects explain much of the uptick, reducing the likelihood of a hawkish pivot from the ECB. Adding to the grim economic narrative, German factory orders dropped sharply by 5.4% in November, marking the second weakest month in a year.

This week, investors will monitor European economic sentiment, retail sales, and German industrial production data. However, the primary focus remains on Friday’s U.S. labour market report, which could further influence global market dynamics.

Sterling Faces Persistent Downtrend Amid Economic and Political Uncertainty

The British pound remains entrenched in a downtrend against the US dollar, a slide that began in October 2024. This decline coincided with improving polling for US President-elect Donald Trump, positive shifts in the US data surprise index, and diminishing expectations for Federal Reserve rate cuts. Conversely, the UK's poorly received autumn budget and disappointing economic data contributed to the pound’s weakness.

Over the past three months, GBP/USD has plunged approximately 8%, falling from $1.34 to a nine-month low below $1.24 last week. This week’s rebound stemmed largely from a weaker dollar, driven by tariff-related news, with stronger UK retail sales figures offering additional support. However, GBP/USD failed to breach its three-month downtrend line. While a close above $1.26 could signal a breakout, the pair has retreated below $1.25 following robust US economic data.

The UK’s fixed-income market also garnered attention this week. A lackluster 30-year bond auction pushed yields above 5.22%, their highest level since 1998, intensifying pressure on the Chancellor to stabilize markets. The Labour government’s plan to sell £297 billion in bonds this fiscal year—the second-highest on record—is keeping gilt yields elevated.

Adding to the uncertainty is a shift in market expectations for the Bank of England (BoE). Traders now anticipate only two quarter-point rate cuts this year, down from expectations of more than three last month. While fewer rate cuts could provide some support for the pound, a prolonged high-rate environment amid weakening economic conditions raises concerns about stagflation, which could limit sterling’s upside potential.

2025 Macro Strategy: Navigating Resilience, Tariffs, and Political Shifts

Looking beyond the short-term perspective, our broader macro strategy for 2025 considers key developments from the past year. In 2024, the global macro landscape was defined by the remarkable resilience of the US economy, buoyed by robust consumer spending and a strong labour market. This strength allowed the Federal Reserve to cut interest rates by 100 basis points, following a rapid decline in inflation over the prior 12 months.

Entering 2025, however, the macro outlook is shifting. President-elect Donald Trump’s potential implementation of higher tariffs, coupled with renewed inflationary pressures, is likely to make policymakers more cautious about further monetary easing. Current market expectations reflect this sentiment, pricing in only a single rate cut for the year—a stark contrast to the six cuts anticipated at the start of 2024.

We believe markets may once again misjudge the trajectory, though in the opposite direction this time. While the US economy remains resilient, the labour market is expected to weaken further. Additionally, recent reports suggest Trump may approach tariffs more pragmatically, which could pave the way for 2-3 rate cuts if inflation remains under control.

On the global stage, political developments are adding layers of complexity. Last year’s electoral shifts to the right have set the tone for 2025, with upcoming elections in Germany and Canadian Prime Minister Justin Trudeau’s resignation introducing uncertainty. While these events may offer temporary support for the US dollar, we remain cautious about the currency’s long-term upside. Ultimately, Trump’s tariff policies will exert a more significant influence than regional political dynamics, and we anticipate less dramatic tariff hikes than market consensus predicts.

The Dollar's Strength Amid Conflicting News and Key Economic Drivers

The dollar's reaction to conflicting news about Donald Trump potentially extending tariffs to all countries underscores how much of its strength relies on the anticipation of broad and early tariff measures. This also suggests that the dollar's recent rally is more influenced by fiscal policies than monetary ones, though the latter remains a strong positive driver.

Last week, the dollar index reached a new two-year high after closing 2024 at its highest annual level in two decades. Key bullish drivers for the dollar in 2025 include a resilient US economy, potential inflationary pressures from robust consumer spending and tariffs, and expectations of a slower pace of Federal Reserve rate cuts. However, we remain cautious, noting that the dollar's extended rally in December may have outpaced its underlying fundamentals when compared to our positive dollar factor index.

Looking ahead, volatility is expected to increase this year, driven in part by uncertainty surrounding Trump’s tariff plans and fiscal policy. In the near term, market participants will closely monitor key macroeconomic data, including today’s JOLTs job openings and ISM services reports, as well as Friday’s non-farm payrolls data.

Euro Gains Amid Tariff News and Inflation Concerns

The euro surged over 1% against the US dollar, climbing from near two-year lows, following tariff news from the US. It has since pared back some gains, trading around $1.04. A rise in German short-term yields, driven by hotter-than-expected German inflation data, also provided broader support for the common currency, though GBP/EUR remains steady near €1.20.

German headline inflation accelerated to 2.6% year-on-year in December, up from 2.2% in November and 1.6% in September. This uptick was largely attributed to less favourable energy base effects. While bund yields have risen and European Central Bank (ECB) easing bets have been pared back slightly, economic sentiment remains fragile, and the growth outlook continues to look weak. Stagflation concerns have resurfaced, but they are unlikely to deter the ECB from cutting rates in January, as markets still fully price in a 25bps cut, with three additional cuts expected through 2025.

For the euro, diverging monetary policy expectations between the Federal Reserve and the ECB remain a significant headwind, reflected in the widening short-dated swap rate differential. While peak European pessimism may signal a potential bottom for the euro, the domestic economic and political landscape remains broadly negative for the currency. Rising gas prices and the threat of US tariffs further contribute to the bearish outlook, cautioning against overly optimistic bets on a euro recovery.

British Pound Rebounds Amid Upbeat Retail Sales and Global Uncertainty

The British pound staged a significant recovery against the US dollar on Monday and has maintained those gains, buoyed by strong UK retail sales data. GBP/USD is back above $1.25, recovering from a dip below $1.24 last week, which had placed it nearly two standard deviations below last year’s average rate of $1.28.

The pound appears to be moving in tandem with the euro, experiencing weakness last week followed by a rebound of over a cent this week. Historically, the two currencies have shown a high correlation due to the interconnectedness of the UK and eurozone economies. Recently, this correlation has intensified, likely driven by shared concerns over looming tariffs and rising gas prices. For the UK, energy dependency amplifies terms-of-trade challenges, adding pressure on the pound. Additionally, the currency’s recent movements underscore its sensitivity to US developments, particularly the uncertainty surrounding tariffs.

Domestically, the pound's bullish 2024 outlook faces headwinds from the October 30 budget and low business confidence, which recently hit a two-year low. While there is a risk of economic surprises skewing negative in 2025, today’s retail sales data offered a brighter note. Retail sales surged 3.1% in December, sharply reversing November’s 3.4% decline and far exceeding expectations of a 0.2% drop.

Supporting the pound further, UK 10-year yields, currently at 4.61%, are near their highest levels since 2008. The yield spread between the UK and Germany remains at multi-decade highs, helping GBP/EUR stay elevated above €1.20.

The US Dollar Maintains Strength Amid Economic and Political Support

The US dollar defied widespread expectations of weakening last year, posting a robust appreciation fuelled by US economic outperformance, a hawkish shift in Federal Reserve (Fed) rate expectations, and the Republican victory in the 2024 election. Over the past four years, the US dollar index has climbed more than 20%, including a 7% rise in 2024 that brought it to its highest year-end level in two decades. Early 2025 has seen a continuation of this trend, with the dollar reaching its strongest point since October 2022 last week, supported by strong US economic data and thin market liquidity.

Even before the election, the US economy’s relative strength was pushing traders to reduce expectations for Fed rate cuts, driving up US yields and boosting the dollar. President-elect Donald Trump’s victory and his proposed policies further bolstered the dollar's bullish outlook. Looking ahead, the dollar’s strength is expected to persist into early 2025, supported by a favourable economic environment, fiscal policies, and potential tariffs.

This week, investors will scrutinise the minutes from the Fed’s December policy meeting for insights into the timing of future rate cuts. Key economic data releases, including factory orders, job openings, ISM services figures, and Friday’s jobs report, will also shape market sentiment.

Although no sharp deterioration in the US labour market is anticipated, a gradual weakening could align with the Fed’s cautious approach to easing amid persistent inflation risks, especially those linked to potential tariff policies. While the dollar is likely to strengthen further, the upward trajectory in 2025 is unlikely to be a straightforward or linear one.

The Pound Struggles as Dollar Strength and Economic Concerns Weigh

The pound enjoyed robust strength in the first half of 2024, driven by a more favourable domestic economic environment, diminished political risks, relative yield advantages, and a supportive global risk sentiment. However, these positive factors have been eroding over recent months. In early 2025, GBP/USD has fallen by approximately 1%, reaching nine-month lows near $1.24.

The decline is primarily dollar-driven, as the US currency continues its rally, supported by resilient US economic growth and elevated yields. The pound’s weakness is also tied to the euro, with their correlation increasing amid shared concerns over potential tariffs and rising European gas prices.

Looking ahead, the pound’s trajectory in 2025 will likely hinge on two factors: the Bank of England’s (BoE) approach to monetary policy easing and the persistence of dollar strength. Despite growing UK-specific worries—such as December’s downgraded manufacturing PMI and business sentiment hitting a two-year low—money markets are currently pricing in only about 60 basis points of BoE easing for the year.

This restrained market expectation suggests that while the pound faces headwinds, its outlook will depend heavily on how these economic and policy dynamics evolve.

The Euro Faces Renewed Pressures Amid Economic and Policy Challenges

The euro has started 2025 on a weak note, slipping to its lowest level since November 2022 and breaking below the $1.03 mark against the US dollar. Hedge funds are increasingly betting on further declines, with parity once again in sight for the coming months.

Despite nearing oversold territory, the euro’s outlook remains clouded by a challenging domestic environment. Weak Eurozone economic growth lags behind major peers, including the UK, while risks of US tariffs and a potential energy crisis further strain the region. The last time EUR/USD reached parity was following Russia’s invasion of Ukraine, driven by a spike in gas prices and a deterioration in the Eurozone’s terms of trade. Current conditions echo that period, with gas inventories depleting at their fastest pace since 2021 and cold weather driving up heating fuel demand, raising fears of another energy crisis.

Diverging monetary policy expectations are also pressuring the euro. The widening short-dated swap rate differential reflects the Federal Reserve’s more hawkish stance compared to the European Central Bank (ECB). This week’s focus will be on Eurozone inflation data for December, where a rebound is anticipated. Any significant upside surprise in inflation could challenge market expectations of four ECB rate cuts this year, potentially offering the euro some stabilisation.

For now, however, the euro remains vulnerable to downside risks, weighed down by cyclical, political, and energy-related concerns.