Worrying signals for UK growth and currency stability
The latest figures from the Office for National Statistics show the UK economy shrank by 0.3% in April compared to the previous month, following a 0.2% fall in March. This was worse than the -0.1% contraction economists had forecast. The timing couldn’t be worse. Just as questions mount over whether the economy can support Chancellor Rachel Reeves’ £190 billion in planned spending, growth appears to be faltering.
The disappointing GDP data rattled markets, triggering an immediate reaction in currency trading. Sterling fell sharply against the US dollar, slipping from 1.3588 to 1.3550. Its performance against the euro also weakened, with the rate dropping from 1.1790 to 1.1767.
Unfortunately, the weaker-than-expected headline GDP figure was not the only bad news. Manufacturing output declined by 0.9% in April, underperforming an already bleak forecast of -0.8%. Meanwhile, the goods trade balance widened further into deficit, reaching -£23.206 billion, as imports outpaced exports. This widening gap means the pound is likely to become increasingly reliant on capital inflows from overseas.
All of this comes just a day after the government outlined its Spending Review, indicating that departmental budgets will rise by around 2.3% annually in real terms. Public service expenditure is projected to increase by approximately £190 billion compared to previous plans. However, this surge in spending comes at a time when the UK is already facing a significant debt burden. Analysts warn that interest payments are nearing £100 billion per year, with the total public-sector deficit forecast to reach £150 billion.
With taxes at historically high levels and borrowing costs comparable to those of the late 1990s, investors are beginning to question how the government intends to fund these ambitious commitments. Rachel Reeves is banking on economic growth to generate enough tax revenue to bridge the gap. Yet, the latest indicators show little evidence of the kind of growth surge needed. The absence of convincing momentum leaves markets nervous.
There is now a growing risk that sentiment toward UK assets could deteriorate rapidly, should investors fear that a fiscal crisis is taking shape. If confidence erodes further, the consequences for the pound could be severe.
Cooling inflation reinforces bets on US rate cuts
The latest US inflation figures suggest price pressures remain subdued. Data released for May showed both headline and core Consumer Price Index (CPI) rising just 0.1% month-on-month. These figures came in lower than April’s numbers and fell short of analysts’ expectations.
On an annual basis, headline inflation inched up slightly to 2.4%, from 2.3% previously, while core inflation held steady at 2.8%. This marks the fourth month in a row where core inflation has failed to meet forecasts, further underlining the ongoing disinflationary trend.
In response, financial markets began factoring in additional interest rate reductions from the Federal Reserve this year. Yields on US government bonds moved lower, while the dollar saw its sharpest daily drop in a week.
The softer inflation readings suggest that the impact of former President Trump’s tariffs has yet to be fully felt by households. This could be due to several factors, including temporary suspensions of duties, businesses choosing to absorb higher costs, or firms having already stocked up ahead of time. At the same time, subdued price growth in domestic services, particularly housing, hints at cautious consumer behaviour and potential concerns about income stability, both of which are limiting the overall inflationary impulse.
For now, the wider consequences of the trade dispute appear to be dampening inflation rather than fuelling it. In theory, this environment favours financial markets. However, early signs that some companies are preparing to raise prices may keep the Federal Reserve alert to the risk of inflation returning, which might explain why equity markets reacted only modestly.
Investors are also closely monitoring how tariffs may gradually lead to higher prices and how this interacts with growing supply at the longer end of the bond market. These developments continue to support a steeper yield curve, a pattern that has played a key role in recent US dollar weakness.
Euro lifted by weak US data and trade tensions
The euro climbed above $1.15 against the US dollar, buoyed by softer US inflation figures and renewed trade threats from Donald Trump. Growing expectations of Federal Reserve rate cuts helped narrow the yield gap between the two currencies, offering support to the euro.
This move was notable, as recent currency shifts have been driven more by sentiment around the US economy than by interest rate differentials. Trump’s latest tariff warning added to market unease, prompting demand for alternatives to the dollar.
EUR/USD broke out of its familiar range between $1.1380 and $1.1445, though momentum may prove short-lived. Stronger US data continues to limit the euro’s ability to retest April highs.
Volatility, once a key driver of euro strength, has also eased. Investors had favoured the euro during times of uncertainty, but recent shifts in European Central Bank policy under Christine Lagarde have brought greater clarity. With rate cuts off the table until after summer, speculative demand has cooled and options market volatility has dropped.
Without fresh catalysts, the euro may struggle to extend recent gains.
