Softer US inflation resets the FX narrative

Market overview

A weaker-than-expected US inflation report has shifted the tone across global markets, pushing Treasury yields and the dollar lower while offering support to equities and major currencies. The data reduced expectations of an imminent Federal Reserve rate increase, although policymakers continue to caution against reading too much into a single release. With energy prices rising sharply and geopolitical risks still elevated, markets face a delicate balance between improving inflation trends and renewed pressure on growth and prices.

USD: Inflation surprise cools Fed rate expectations

US inflation slowed more sharply than forecast in June. Headline CPI fell 0.4% month on month, against expectations for a 0.1% decline, while the annual rate eased to 3.5% from 4.2%. Core inflation was unchanged on the month and slowed to 2.6% annually, also below consensus.

Lower energy prices drove much of the headline decline, with gasoline prices falling 9.7%. However, softer shelter costs and subdued underlying services inflation gave investors greater confidence that price pressures were easing more broadly.

Markets largely removed the prospect of a July rate increase, sending the two-year Treasury yield around eight basis points lower to 4.2%. The dollar weakened across the major currency pairs as traders reduced expectations of a more aggressive Fed response.

Fed Chair Kevin Warsh nevertheless warned against declaring victory over inflation. Price growth remains above target, while geopolitical and energy risks could complicate the outlook. The dollar may remain under pressure in the near term, but resilient employment and persistent inflation risks should limit the scale of any sustained decline.

GBP: Sterling gains fade as domestic risks return

GBP/USD approached 1.34 following the softer US inflation release, as markets pushed expectations for the next Fed rate rise from September to October. A further increase remains priced before year-end, limiting the potential for a sustained sterling rally based solely on weaker US rate expectations.

A softer US Producer Price Index reading, alongside any improvement in relations between the US and Iran, could help the pair make a firmer move above 1.34. Without those catalysts, further gains may prove difficult.

GBP/EUR has retreated from its one-year high of 1.1772 after an increasingly stretched rally. The pullback remains modest, and the broader technical trend continues to favour sterling, although some analysts believe the recent advance has run its course.

Domestic political and economic developments are likely to become more influential. Investors will focus on Andy Burnham’s choice of Chancellor and the implications for fiscal policy. A candidate viewed as more supportive of increased public spending could weaken confidence in the pound, while Wes Streeting is regarded as a more market-friendly option.

June’s UK inflation report, due on 22 July, is another key risk. A softer reading could reinforce expectations of a less restrictive Bank of England stance, particularly if followed by cautious MPC communication on 30 July. GBP/EUR may therefore be more likely to consolidate between 1.16 and 1.17 than extend its recent rise.

EUR: Rate support offsets growing energy concerns

The euro has remained resilient despite a 12% rise in oil prices this week following renewed tensions in the Gulf. EUR/USD has moved back above its 21-day moving average, supported by softer US inflation and a renewed increase in ECB rate expectations.

The two-year EUR/USD swap differential has narrowed by more than 20 basis points since the start of July. This has provided the euro with short-term support after a period dominated by wider rate spreads and stronger US economic performance.

However, the improvement remains vulnerable to further increases in energy costs. The eurozone is more exposed than the US to higher oil and gas prices, which could weaken growth, worsen the region’s terms of trade and reduce competitiveness.

European gas prices are particularly important because they have a more direct effect on household costs, industry and the wider economic outlook. ECB repricing may continue to support the euro temporarily, but a prolonged energy shock would likely become the more powerful market driver.

Looking ahead

• US Producer Price Index data for further evidence of easing inflation.

• Kevin Warsh’s testimony before Congress and any guidance on future Fed policy.

• Developments in US-Iran relations and the wider outlook for Gulf energy supplies.

• UK CPI on 22 July and its implications for Bank of England expectations.

• MPC communication on 30 July.

• European oil and gas prices, with further gains likely to challenge euro resilience.