The British pound climbed to its highest level since mid-March against the US dollar yesterday, driven by improved global risk sentiment and thin trading conditions due to holidays in the US and UK. GBP/USD is hovering just below the $1.28 mark, nearly 4% above its 2024 low of around $1.23 and just one cent short of its 2024 high. Against the euro, sterling is near nine-month peaks, only 30 pips shy of €1.18 and almost 2% higher than its 2024 low of €1.1560 recorded at the end of April.

The primary factor behind the recent strength of the pound was the hotter-than-expected inflation report published last week, which drastically reduced the probability of a June rate cut by the Bank of England (BoE) from 50% to 10%. Currently, money markets are pricing in fewer than two BoE rate cuts for 2024, with a total easing of 30 basis points expected by year-end, which we consider overly dovish. Consequently, yields on UK Gilts surged to one-month highs, and the UK-US yield spread reached a two-month high, propelling GBP/USD to an 11-week peak.

Election news has not negatively impacted sterling so far, but this could change if polls show the incumbent Conservatives closing the gap, increasing uncertainty. Nonetheless, neither party is proposing radical fiscal policy shifts, and both are likely to avoid spooking financial markets, unlike former PM Truss did in October 2022. Therefore, this election campaign might be less volatile, with the direction of UK assets, including the pound, likely driven more by fundamental economic factors and the timing and pace of BoE rate cuts.

While the spot market has remained relatively calm regarding election news, the options market reflects anticipated volatility, with 2- and 3-month implied volatilities, which cover the election date, spiking higher. The biggest risk to sterling in the coming months, which could push GBP/USD back below $1.25, is a surprise June rate cut by the BoE or a hung parliament in the election, but both scenarios are currently considered tail risks.

The British Pound declined against both the Euro and the Dollar following a significant drop in UK retail sales for April. However, markets appear to be looking past these figures due to the impact of adverse weather conditions.

According to the ONS, retail sales dropped by 2.3% month-on-month in April, far below the expected -0.4%. Annually, sales fell by 2.7%, missing the forecasted -0.2%.

Upon the release of this data, the Pound to Euro exchange rate initially fell but quickly rebounded to around 1.1737. Similarly, the Pound to Dollar exchange rate dropped to 1.2672 before recovering to 1.2690.

The brief dip in the Pound indicates that investors are disregarding the weather-affected figures, anticipating a rebound in May. Additionally, retail sales are expected to recover in the coming months, supported by a strong job market and declining inflation.

Although the monetary value of retail sales has steadily increased in recent months, the volume of goods sold continues to decline. This trend is due to inflation, which is driving up costs and reducing the quantity of purchases.

With inflation expected to fall back near the Bank of England's 2.0% target in the coming months, the value of sales could stabilise. Meanwhile, increasing real incomes may lead to a rise in sales volume.

The Pound is likely to withstand any post-retail sales volatility due to reduced expectations for a Bank of England interest rate hike following Wednesday's inflation report.

The big news from the UK is Prime Minister Rishi Sunak's announcement of a general election on July 4th, much sooner than expected. Opinion polls indicate a likely victory for the opposition Labour Party, which has maintained a steady 20-point lead over Sunak’s Conservatives since the beginning of the year. Sterling has held its gains driven by inflation, while UK gilts continued to sell off as expectations for a Bank of England (BoE) rate cut diminished further.

Sterling surged to a two-month high of $1.2760 against the US dollar yesterday as the UK-US rate spread narrowed following the UK inflation report. Services inflation, closely monitored by the BoE, came in at 5.9% year-on-year for April, higher than the 5.4% forecast. Consequently, recent expectations for a dovish BoE rate cut were significantly reduced, with the likelihood of a June cut dropping from 50% to 10%, making an August cut seem more probable. Gilt yields rose across the curve, with the 2-year yield experiencing a nearly three-sigma move, rising by 15 basis points in a day—the largest daily increase in over a month.

The early election call by Sunak followed his declaration that inflation was “back to normal,” referencing the decrease in headline CPI from 11% in October 2022 to 2.3% in April 2024. However, persistent services inflation might delay BoE rate cuts, which explains the market's recent reaction. The lack of significant market response to the snap election highlights the greater importance of inflation and monetary policy for FX traders. Moreover, many political commentators consider a Labour victory almost certain. Despite this, the event is not devoid of uncertainty; GBP implied volatility for two-month and three-month tenors rose to multi-week highs, and risk reversals are becoming less pound bearish.

While markets typically favour continuity, a Labour government is anticipated to bring political stability. The prospect of a closer relationship with the EU under Labour could reduce some of the pound’s Brexit premium. Additionally, the party’s shift towards a more pro-business, centrist stance could further support sterling.

Sterling is rising across the board after data released this morning showed that UK inflation neared the Bank of England’s (BoE) 2% target but did not slow as much as expected. This has left the likelihood of a June rate cut unchanged at around 50%. GBP/USD and GBP/EUR have both reached new 2-month highs at $1.2760 and €1.1740, respectively.

Inflation peaked at 11.1% in October 2022, its highest in 40 years. Since then, there has been significant progress in reducing price pressures, with the headline consumer price index dropping to 2.3% year-on-year in April—its lowest since the summer of 2021 and a substantial decrease from the 3.2% recorded in March. However, this fall in inflation did not meet the consensus forecast of 2.1%, which was also the BoE's expectation. Prices of electricity, gas, and other fuels fell by 27.1% year-on-year, the largest drop since records began in 1989. Additionally, core inflation, which excludes volatile food and energy costs, fell to 3.9% from 4.2%. Services inflation, closely monitored by the BoE for signs of domestic pressure, was expected to slow to 5.5% but remained relatively unchanged at 5.9% after a 6% reading the previous month. This is significant and is a key reason why a June rate cut might be off the table.

UK inflation is narrowing in scope, with over 40% of items in the CPI basket now under the 2% target. However, there is still a way to go for the BoE, with over 12% of items still rising at a pace of 6-8%. Moreover, because the latest figures exceeded forecasts, particularly in services inflation, this is a major setback for those advocating a BoE rate cut in June, and it explains why the pound has appreciated this morning.