UK Economy Faces Stagflation

UK Economy Faces Stagflation

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.

Please note:  The news and information contained on this site should not be interpreted as advice or as a solicitation to offer to convert any currency or as a recommendation to trade.

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