Pound Under Pressure as Bank of England Signals Potential Rate Cuts

The pound faced downward pressure after the Bank of England (BoE) kept its Bank Rate steady at 4.75%, as expected. The market-moving development came from three policymakers voting for a rate cut, compared to the previous 8-1 split favouring a hold. This shift sent a dovish signal, lowering short-dated gilt yields and weakening sterling.

The greater dissent surprised markets, though it was supported by the committee’s dismissal of stronger pay data as “more volatile than other wage indicators.” Additionally, softer data on economic activity and employment appeared to influence the decision. Analysts now anticipate the BoE will likely cut its key interest rate by 25 basis points in February, continuing a “cut-hold” approach. Market expectations for a February cut have risen from 50% to over 70%, though just 57 basis points of rate cuts are priced in for 2025—well below the 100 basis points projected by BoE Governor Andrew Bailey. Should market pricing adjust to align with BoE projections, the pound could face further depreciation in 2025.

The GBP/USD pair has dropped to a six-month low, slipping below its key support and the $1.25 Interbank (IB) support level. With the relative strength index yet to signal oversold conditions, further declines are possible. Meanwhile, GBP/EUR has fared better, buoyed by favourable rate differentials and the euro’s internal bearish factors.

UK Retail Sales Highlight Consumer Caution Amid Economic Slowdown

New data from the ONS reveals continued caution among UK consumers, adding pressure on retail businesses and offering further signs that the economy has entered a downturn.

Retail sales rebounded from a -0.7% decline month-on-month in October to a modest 0.2% growth in November, falling short of market expectations of 0.5%. Notably, November is typically a crucial month for UK retailers due to the Black Friday shopping event, making the weaker-than-expected performance particularly concerning.

Retail sales, a key indicator of demand and sentiment in the UK's service-driven economy, play a vital role in shaping overall economic performance. The weaker-than-expected figures provide further evidence of declining momentum as the economy heads toward year-end, adding to a series of recent disappointments.

Euro Faces Challenges Amid Fed-ECB Divergence and Weak Data

The euro appears to be consolidating support near the $1.0350 IB level, as it grapples with widening policy divergence between the Federal Reserve and the European Central Bank (ECB), coupled with weak domestic economic data. A close below $1.0410 at IB today would mark the euro's lowest weekly close against the dollar this year. The final opportunity for euro bulls to shift momentum before the weekend lies in the release of the US PCE inflation report. Consensus forecasts suggest a decrease in core price growth from 0.3% in October to 0.2% in November, while personal spending is expected to rise from 0.4% to 0.5%.

Upside surprises in consumption data remain a possibility, which could hinder the euro’s ability to recover and end the week positively. Such an outcome would mean EUR/USD has declined in six of the past seven weeks. With no significant economic data expected until year-end, the currency pair is on track to close 2024 with a loss. Additionally, if the euro fails to climb back above $1.05 at IB within the next 11 days, it will record its lowest annual close since 2002.

Market Sentiment Deteriorates Amid US Spending Bill Failure

Financial markets turned sour to close the week after a bill to extend US government funding until March 14 failed to secure the required two-thirds majority in Congress. With a deal needed today to avoid a government shutdown, equities futures have fallen into negative territory, while the US dollar—bolstered by its safe-haven and high-yielding appeal—has gained modest strength against other currencies.

The House of Representatives rejected the Trump-backed spending package, prompting concerns over future legislative chaos should Trump return to the White House. This risk-off sentiment has kept the US dollar index hovering around 108.5, its highest level since November 2022. Investors are also closely watching the release of the PCE price index, the Federal Reserve's preferred inflation gauge, which is expected to show inflation still above the Fed’s 2% target.

The Fed’s recent quarter-point rate cut, delivered alongside hawkish guidance, highlighted persistent inflationary pressures. The central bank now anticipates only two rate cuts in 2025, a sharp reduction from the four cuts projected in September, signalling a more cautious approach to monetary easing.

Federal Reserve Concludes Year with Third Rate Cut Amid Rising Inflation Concerns

The Federal Reserve has reduced interest rates by 25 basis points, concluding the year with a total of three rate cuts amounting to a 1% easing. This adjustment brings the federal funds rate to 4.25%. The Summary of Economic Projections indicates a median forecast of two rate cuts next year, alongside an upward revision of the year-end inflation projection for 2025 to 2.5%.

Policy makers appear to have underestimated inflation risks in recent years. Since the early price increases in 2021, the Federal Open Market Committee (FOMC) has primarily focused on its preferred measure, core PCE inflation. By 2022, their stance became more cautious than inflation data warranted. This caution eased in September, as only three FOMC members then perceived upside risks to core PCE inflation.

However, inflation concerns have resurfaced. The number of FOMC members recognizing upside risks to core PCE rose sharply from three to 15, marking the largest meeting-by-meeting increase since 2017. The median inflation forecast for 2024 also rose from 2.1% to 2.5%. This upward revision, combined with dissent from Cleveland Fed President Beth Hammack and heightened inflation risk perception, sets the stage for a potential pause in rate adjustments at January’s meeting. Investors interpreted this meeting as a hawkish signal despite the rate cut.

Euro Slips Below $1.04 as Fed’s Hawkish Cut Rattles Markets

The euro dropped below the critical $1.04 support interbank (IB) level for only the second time this year after the Federal Reserve delivered a hawkish rate cut yesterday evening. The move unsettled global equity markets, with investors reacting to the possibility of a more cautious stance from the US central bank, resulting in widespread losses across major indices.

The VIX, a key measure of implied stock market volatility, surged, doubling its level after the Fed meeting and setting up for its largest weekly increase since the pandemic. Market attention now shifts to central bank decisions in Norway, Sweden, the UK, Mexico, Taiwan, and the Philippines, with investors watching closely for any ripple effects from the Fed's policy shift.

As anticipated, the euro’s movements remain closely tied to US developments. Following the Fed’s decision, markets are now bracing for tomorrow’s US inflation data. Meanwhile, today’s GfK consumer survey from Germany failed to lift spirits, as consumer confidence remained in negative territory for December—a trend persisting since late 2021.

Bank of England Expected to Hold Rates Steady Amid Inflation Concerns

The Bank of England (BoE) is anticipated to leave the Bank Rate unchanged at 4.75% today, aligning with consensus expectations and market forecasts. Investors will focus on the vote split and any forward guidance, particularly whether the BoE hints at a potential rate cut in February or adopts a more cautious stance, akin to the Federal Reserve, in response to unexpected wage growth.

The Monetary Policy Committee has signalled a measured approach to policy easing, interpreted as quarterly rate cuts, which are likely to extend into 2025 given that economic data aligns with their projections. However, this week’s strong UK wage growth and persistent inflation have tempered market expectations, reducing anticipated rate cuts next year to fewer than two 25-basis-point reductions. UK gilt yields are approaching one-month highs, with the UK-German 10-year spread reaching levels last seen in the 1990s, pushing GBP/EUR past the €1.21 IB mark.

Meanwhile, GBP/USD is edging closer to the $1.26 IB level after the Fed’s hawkish decision last night. The pair experienced its steepest decline in over a month and remains in a downtrend since peaking at $1.34 at IB in late September. A hawkish tone from the BoE today could offer some relief, though short-term prospects for GBP/USD remain uncertain.

Fed Rate Decision: Hawkish Signals or Dovish Surprises?

The US Federal Reserve is widely expected to deliver another 25-basis point rate cut later today, with markets assigning a 95% probability to this outcome. Consequently, market volatility is more likely to stem from the Fed’s updated dot plots and economic projections. Should the tone lean unexpectedly dovish, the USD could weaken, especially given its 6% rally this quarter.

Market sentiment is largely tilted toward a hawkish stance, supported by ongoing US economic strength and the potential for fiscal stimulus under President-elect Donald Trump. Recent data highlights this resilience: US composite PMI climbed to its highest level since March 2022, driven by strong performance in the services sector, while retail sales rose 0.7% month-on-month in November, following an upwardly revised 0.5% gain in October. These indicators point to robust consumer spending and business activity, prompting markets to scale back expectations for further rate cuts next year. The projected interest rate path now exceeds the Fed’s current dot plot, setting a high bar for additional easing.

Additionally, policymakers may revise their inflation outlook as they prepare to pause rate cuts in January. In September, only three FOMC members anticipated upside risks to core PCE inflation, but this assessment is likely to shift higher. However, if upgrades to the 2025/26 economic forecasts fall short of market expectations, the USD may face downward pressure.

Sterling Slips as UK Inflation Meets Expectations

The pound retreated from yesterday’s highs after UK headline inflation for November came in line with forecasts. While core inflation reached a three-month high, a closely watched measure of services inflation, important to Bank of England (BoE) policymakers, was slightly lower than anticipated. As a result, GBP/EUR has dropped below €1.20 at Interbank (IB), and GBP/USD has slid back under $1.27 IB.

This inflation release was the final major data point ahead of the BoE’s last policy meeting of 2024, scheduled for Thursday. Strong wage growth data from yesterday led traders to reduce expectations for BoE rate cuts next year, with markets now pricing in two cuts in 2025, down from three earlier this week. However, despite resilient wage growth and persistent inflation, signs of weakness in the labour market and slowing economic activity are fuelling concerns over stagflation. This growing uncertainty suggests sterling may find less support from elevated UK rates moving forward.

Euro Slides Below $1.05 Amid Strong US Data and German Political Turmoil

The euro dipped below the $1.05 IB level as stronger-than-expected US macroeconomic data and escalating German political uncertainty weighed on the currency. In November, political instability in Europe’s largest economies reached new highs, with governments either collapsing or operating in minority positions as fiscal deadlines loom.

France is projected to grow modestly by 0.2% in the first half of 2025, according to the Insee institute. However, Germany faces a potential third consecutive year of contraction in 2025, further clouding the region's outlook.

Key catalysts for the euro’s near-term direction include developments in German and French politics, as well as the Federal Reserve’s policy decision later today. A sustained break below $1.05 IB by the end of the week could signal deeper trouble for the currency.

A Shift in Inflation Risk Perception: US Policymakers May Have Jumped the Gun

US policymakers appear to have gotten ahead of themselves in their lenient assessment of inflation risks. Since prices began rising in early 2021, the Federal Open Market Committee (FOMC) has largely aligned its risk perception with its preferred inflation gauge, the core PCE index. However, starting in 2022, policymakers adopted an even more cautious stance than inflation trends warranted. This dynamic changed in September, when only three FOMC members perceived upside risks to core PCE. We anticipate this assessment will shift upward as the Federal Reserve prepares to pause its easing cycle in January.

Euro Struggles Amid Economic Divergence, but Seasonal Recovery Possible

The euro is facing pressure near the $1.05 level against the USD at the start of the week, despite flash PMI data underscoring the significant divergence between European and US economic activity. The December flash PMIs for Europe point to persistent economic weakness, with the continent stagnating in the fourth quarter.

While the composite PMI remains below the 50 threshold, signalling no expansion, it has recovered much of November's decline. This improvement stems from a notable rebound in the headline services index, which climbed 1.9 points to 51.4. Geographically, France continues to lag, particularly with a dismal manufacturing survey, though its services PMI showed some resilience. In Germany, better-than-expected services PMI results boosted the nation’s composite PMI. Despite this, the broader narrative remains unchanged: the European Central Bank (ECB) is likely to cut rates more deeply and aggressively than the Federal Reserve in 2025, keeping both nominal and real interest rate differentials tilted in favour of the dollar.

Although the euro is down 0.75% this month, seemingly defying typical seasonal patterns, history suggests the common currency often strengthens during the final two weeks of December. A modest euro recovery over the festive period is still possible. However, Q1 2025 is likely to present challenges due to monetary policy divergence, political headwinds in Germany and France, and the looming risk of severe trade tariffs if Trump is inaugurated.

UK Data Sparks Sterling Gains as Wage Growth Surprises

A wave of UK economic data has already hit this week, with the composite PMI holding steady, supported by the services sector. Notably, there was a slight downtick in employment and an uptick in prices. The unemployment rate matched expectations at 4.3%, but wage data came in hotter than anticipated. This has led to modest sterling appreciation across FX markets, with GBP/USD and GBP/EUR approaching $1.27 and €1.21, both gaining nearly a cent since yesterday.

Private sector business activity continues to show slight expansion, marking the 14th consecutive month of growth. Strength in services offset another contraction in manufacturing. However, beneath the surface, there are signs of concern. UK private-sector firms cut jobs at the fastest pace since the global financial crisis (excluding the pandemic), likely reflecting concerns over employment costs as the new budget raised payroll taxes. New orders also fell for the first time in 13 months, casting doubts on future spending trends. Rising wages further pushed average prices charged to their fastest increase in nine months, raising fresh concerns for Bank of England (BoE) policymakers ahead of their final policy meeting of 2024 this Thursday.

This morning’s labour market data highlighted wages as the key driver lifting the pound. Regular wage growth accelerated more than expected in the three months through October, with private-sector regular pay growth—a measure closely watched by the BoE—rising to 5.4% from 4.9%. As a result, money markets have scaled back expectations for UK interest rate cuts in 2025, trimming roughly 10 basis points to price in a total of 62 basis points of cuts, or fewer than three 25bps reductions.