Surprising increases in US producer and consumer prices last week have prompted a downward adjustment in market expectations for the Federal Reserve's potential interest rate cuts this year. Current futures pricing indicates a projection of approximately 90 basis points in cuts for 2024, down from the 160 bps forecasted at the end of the previous year. This shift has resulted in a rise in US yields, bolstering the US currency across various markets.

While goods prices continue to decrease, service inflation, even when excluding shelter costs, remains persistently resistant. This resilience supports the stance of Federal Reserve officials resisting an immediate rate cut. The stock market experienced a mild reaction, initially responding to the higher-than-expected inflation report with a setback but recovering as data revealed a slowdown in economic activity through weak retail sales.  It's important to note that January economic reports tend to be noisier due to the volatile impact of holidays, weather, and one-off events typical in the first month of the year.

Looking ahead, key events include the release of US consumer confidence, existing home sales, and flash PMIs this week. However, Wednesday is particularly crucial with the publication of the Fed's meeting minutes and the quarterly earnings report for Nvidia, a significant player in the market. Presently, the strength of the USD is not only due to its appeal but also reflects a lack of attractiveness in other assets. The ongoing trend is expected to persist until there is a shift in market sentiment or when the Fed decides to implement rate cuts, signalling a potential resumption of the USD downtrend.

GBP initially gained support from last Tuesday's unemployment figures, which showed a lower rate of 3.8% in January compared to the forecasted 4.0%, coupled with stronger-than-expected wage growth at 5.8% versus the anticipated 5.6%. However, on Wednesday, GBP faced pressure as a weaker inflation result was reported, and Thursday confirmed that the UK had entered a recession. GBP experienced a boost on Friday when data revealed that UK retail sales had surged at their fastest pace in almost three years in January.

Despite the recent setbacks, expectations regarding the Bank of England's (BoE) monetary policy outlook remain more hawkish compared to other major central banks. The likelihood of BoE interest rate cuts has reduced, with less than three 25 basis points of cuts projected for 2024. This has helped limit the weakness of GBP, allowing GBP/EUR to regain the €1.17 level, although it had fallen sharply from its recent 18-month highs and suffered a third consecutive weekly decline. GBP/USD also declined for a third straight week but found support at its 50-week moving average and is now back above the $1.26 mark at the beginning of the week.

While fundamental risks persist due to growth differentials favouring the still-high-yielding USD, there is agreement in the market that the BoE is likely to maintain higher interest rates than the Federal Reserve (Fed) and the European Central Bank (ECB) for an extended period. This expectation supports GBP over the long term, given the preference for yield differentials.

The key domestic risk event for GBP traders this week will occur on Thursday when flash PMIs for February are released. Positive readings, building on the improvements seen in January for both manufacturing and services sectors, are expected to further bolster demand for GBP.  GBP currently remains well supported, and there is no apparent reason for this trend to change over the next few weeks.

EUR maintains a lateral trading pattern against the USD, staying above the $1.07 level, situated squarely within its six-month trading range. Despite the reduction in cumulative rate cut expectations for ECB easing by the year-end, any potential upward movement for the EUR/USD seems constrained, with a heavy resistance at $1.0850.

Following yesterday's revelation that the UK entered a technical recession at the close of last year, today's positive retail sales data helps explain the Bank of England's (BoE) lack of concern about the GDP figures. UK retail sales experienced the most significant monthly increase in nearly three years, fostering optimism that the economy has already stabilized. While the pound showed a modestly positive response, its performance remains mixed across the board for the week.

In January, the volume of goods sold in both physical stores and online in the UK surged by 3.4%, marking the highest growth since April 2021 when the economy was emerging from lockdown. This exceeded expectations of 1.5% and aligns with recent survey findings indicating an uptick in economic momentum as the severe cost-of-living crisis, the worst in a generation, begins to ease. The positive news comes as a welcome relief for UK Prime Minister Rishi Sunak, who had to contend with yesterday's recession headlines. Although the Conservative Party has been facing mounting challenges, the likelihood of staying in power this year seems to be diminishing, especially after the opposition Labour Party overturned significant Tory majorities to secure two parliamentary seats overnight.

Surprisingly, financial markets, particularly UK assets, have shown a relatively muted reaction to these developments. This holds true for GBP/EUR, where implied volatility has dropped to its lowest level since 2007. The currency pair has experienced a slight increase, reaching €1.17, and while volatility remains low, the pound is poised to benefit from carry trades. On the other hand, GBP/USD hovers around the $1.26 mark following a modest temporary increase. Despite this, the pound is still on track for a weekly loss against the dollar, marking its fifth decline out of seven weeks, given the impact of this week's significant data releases.

This morning's GDP data unveiled that the UK experienced a technical recession last year, with the fourth-quarter figure registering at minus 0.3%, falling below expectations. GBP/USD is currently trading in the mid-$1.25 range and is contending with its 200-day moving average. In the event that this crucial support level falters, our attention turns to the 100-day moving average at $1.25 as the next short-term downside target.

All three major sectors of the UK economy contracted from October through December. The services sector, constituting approximately three-quarters of the economy, saw a decline of 0.2%. Production, encompassing manufacturing, suffered a 1% drop in output, while construction contracted by 1.3%. Although the economy has contracted for two consecutive quarters, the GDP estimate for 2023 indicates a 0.1% increase compared to 2022.

For the Bank of England (BoE), the result has minimal impact on the interest rate outlook. Of greater significance, recent data revealed lower-than-expected UK inflation in January, with declining costs of food and household goods fostering expectations that inflation could approach the BoE's target by summer. The pound experienced widespread daily declines as traders anticipated more pronounced and earlier interest-rate cuts. The current market outlook suggests the BoE will implement just over 70 basis points of cuts this year, up from 61 basis points at Tuesday's close following stronger-than-expected wage growth figures.

Despite the short-term prospects for sterling appearing potentially weaker, we maintain the view that 2024 could witness a modest recovery against the US dollar and euro. This optimism is primarily rooted in the higher UK interest rate outlook, with expectations of fewer rate cuts by the BoE compared to the Fed and ECB.