Pound Sterling's Post-Inflation Weakness Against Euro and Dollar Has Some Obvious Limits

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The British Pound fell sharply following the release of below-consensus UK inflation numbers, but there are reasons to believe losses can remain relatively contained.

The surprise fall in headline CPI inflation to 3.9% year-on-year was the kind of surprise that can significantly shift expectations for the UK economy and interest rates.

Markets reckon falling inflation will be met with a swift reaction at the Bank of England and now see over 125 basis points of rate cuts falling in 2024, with the first cut now priced for as early as March.

This increase in rate cut expectations is reflected in lower UK bond yields and a lower Pound; Pound to Euro looks intent on retesting 1.15 while the Pound to Dollar conversion is looking to 1.26 next.

Therefore, the Pound will likely keep falling should this trend continue. "GBP weakness is likely to continue as well in light of the dovish interest rate pricing," says Thanim Islam, Head of FX Analysis at Equals Money.

"The favourable developments are reinforcing market expectations that headline inflation could fall back to the BoE’s 2.0% target in 1H of next year, setting the stage for the BoE to begin cutting rates from Q2. While it is in line with our current forecasts for BoE policy, the faster decline in inflation poses downside risks to our near-term pound forecasts," says Lee Hardman, Senior Currency Analyst at MUFG Bank Ltd.

But rate cut pricing is now heavily pregnant at +150bp, and it is hard to see the market bringing the expected timing of the first rate cut forward beyond March.

"We believe that the five rate cuts that the markets are currently pricing in for 2024, beginning in May, are overdone," says David Alexander Meier, an economist at Julius Baer. In short, we are reaching a point where the path of least resistance for interest rate expectations will be lower, which can limit GBP weakness. A clearer reversal of such expectations can defend the Pound.

Above: Rate cut expectations have fallen sharply over the past month; how much lower can they go?

But the trigger for such a reversal is unlikely anytime soon, particularly as the Bank of England's Monetary Policy Committee members have consistently and unequivocally said the market was getting ahead of itself.

"We now expect the BoE to implement its first rate cut in June and to cut three times to 4.5% until year-end, compared to our previous forecast of only two cuts starting in September," says Meier.

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He explains that the Bank won't be able to meet market expectations as declines in core inflation are still limited to volatile segments such as transportation and recreation; in addition, risks to wage growth remain skewed to the upside despite a recent drop to 7.2%.

If this assessment is correct, a repricing in favour of Pound Sterling strength must happen at some point.

And let's not forget that falling UK inflation and a belief that interest rates will fall in 2024 will support the improvement in consumer and business sentiment over recent weeks.

The big takeaway from the midweek inflation release is that the UK faces a significantly improved economic outlook in 2024, which can only support Sterling medium-term.