UK inflation falls to 2.5yr low

Despite UK inflation figures falling below expectations, GBP displayed remarkable resilience, potentially steering the Bank of England (BoE) towards interest rate cuts in the summer.  Initially, the GBP/EUR exchange rate dipped to 1.1684 in response to news of UK CPI inflation coming in at 3.4% in the twelve months leading to February 2024, a decrease from January's 4.0% and below the anticipated 3.6% by consensus.  This marks the softest inflation reading since September 2021, registering at 3.1%.

Core CPI, excluding energy, food, alcohol, and tobacco, saw a 4.5% increase in the twelve months leading to February 2024, down from January's 5.1% and below the expected 4.6%.  Services inflation, a significant metric for the BoE, eased from 6.5% to 6.1%. Despite the GBP's initial decline, it rebounded swiftly, contrary to the usual reaction to such undershooting inflation numbers.

The Office for National Statistics (ONS) reports that the most substantial downward contributions to the monthly change in inflation stemmed from food, restaurants, and cafes, while housing, household services, and motor fuels made the most significant upward contributions.  These statistics precede the BoE's Thursday policy announcement, where interest rates are projected to remain unchanged at 5.25%, though guidance remains uncertain.

Today, the attention now shifts to the US Federal Reserve.  The Fed is anticipated to adopt a more stringent stance on policy due to higher-than-expected inflation and a robust job market, maintaining pressure on the US central bank to uphold elevated interest rates.

EUR/USD remains bearish

Financial markets commenced the week cautiously, with multiple central banks poised to announce their monetary policy decisions in the coming days. EUR/USD slipped below its support level at $1.0880 (14-day SMA) as investors scaled back expectations of a June rate cut by the Fed, yet it continued to trade steadily above the $1.0850 barrier.

As anticipated, the final Eurozone inflation rate for February was confirmed at 2.6% y/y (a 3-month low), indicating ongoing disinflation in the euro area. While lower inflation is deemed necessary, it alone does not suffice for the European Central Bank to lower its policy rates from the historically high 4%. The Governing Council is closely monitoring wage developments to assess whether domestically driven cost pressures are subsiding in a sustainable manner. Should wage growth continue to moderate, as anticipated, the first rate cut is likely to occur in June. Interest-rate traders are positioning for a rate cut in Q2, with an anticipated 85 basis points of cuts by year-end, with a 63.8% probability of a rate cut in June.

What can we anticipate heading into FOMC decision week? Over the past 14 meetings, EUR/USD has typically closed within a 0.3% band of the day's bid open on the eve of the Fed decision, with no statistically significant trend indicating a marginally bullish or bearish trajectory. With overnight ATM options for EUR/USD not pricing in increased volatility, we expect the euro to maintain a neutral stance against the US dollar, with investors hesitant to initiate large last-minute positions. Consequently, it's possible that markets may not react significantly to today's Eurozone wage growth report and German ZEW survey, choosing instead to await the FOMC decision on Wednesday. The target range for EUR/USD today is $1.0840 to $1.0900, although sentiment remains bearish.

BoJ hike

In a momentous departure from years of extensive monetary stimulus, the Bank of Japan (BoJ) concluded an eight-year period of negative interest rates. This move triggered a decline in the yen's value and a drop in Japanese government bond yields, illustrating the classic phenomenon of "buy the rumour, sell the fact."

The BoJ elevated its primary short-term interest rate to approximately 0% to 0.1% from its previous -0.1%, marking Japan's first rate increase since 2007. This decision came as inflation had surpassed the central bank's 2% target for over a year, alongside major companies in the country agreeing to the most significant wage hikes in 33 years. Concurrently, the central bank ceased its yield curve control for 10-year government bonds. However, in its policy statement, the bank affirmed it would continue purchasing bonds at similar levels, indicating that the BoJ isn't adopting a hawkish stance.

Despite interest rates remaining close to zero, the yen continues to function as a funding currency and is expected to continue being utilized for carry trades. Consequently, the yen has depreciated broadly against other currencies, with USD/JPY surpassing the ¥150 mark and GBP/JPY approaching ¥191—levels close to its highest point since 2015.

Monfor Weekly Update

GBP has experienced a decline of approximately 1.3% from its recent peak against the US dollar, reaching $1.2857, marking a 7-month high.  Last week the foreign exchange majors were largely influenced by US inflation data.  In addition, although UK wage growth pressures have been easing, they remain relatively high, while UK GDP showed signs of improvement in January.

The Bank of England (BoE) is anticipated to maintain its current interest rate at 5.25% until there are clearer indications of a slowdown in pay growth and services inflation.  The decision from the BoE, scheduled for this Thursday, will be influenced by the latest UK inflation data, particularly regarding services inflation, which surged to 6.5% in January.  The timing of the BoE's first rate cut hinges on this data.  Unless there is a significant downside surprise in inflation, it is expected that the BoE will restate its previous guidance, emphasising the need for sustained restrictive rates.

Currently, the market anticipates a total easing of 60 basis points for 2024, with the initial cut projected for August.  This week is notable for a series of central bank decisions, potentially leading to divergence in the timing and magnitude of monetary easing, thus increasing foreign exchange volatility.

Despite last week's hawkish reassessment of UK rates, the overall hawkish stance of G3 central banks adversely affected the GBP. The expected trajectory of monetary policy among G3 central banks is largely similar, making the extent of anticipated monetary easing a key factor. Increased expectations of rate cuts are conducive to the growth outlook for high beta currencies like the GBP against the USD. Consequently, despite the GBP's recent hawkish repricing, the broader hawkish shift in G3 policy weighed on its performance.

USD gains on inflation data

US inflation figures continue to veer unfavourably from the Federal Reserve's perspective, with the fifth consecutive inflation report surpassing expectations.  January witnessed CPI, PPI, and PCE inflation outperforming forecasts, which dampened expectations for easing in 2024.  February appears to mirror the trend of elevated figures from the previous month, with both consumer and producer prices once again surpassing consensus estimates this week. Producer prices increased by 0.6% for the month, elevating the annualized growth rate from 1.0% to 1.6%.  Another report indicated that initial jobless claims remained at historically low levels (209k), suggesting that the easing of labour market tightness, as indicated by other indicators, is progressing moderately.  Despite retail sales experiencing a lower-than-expected rise in February (0.6% vs. 0.8% expected), the market ultimately leaned towards trusting the inflation outperformance over the disappointment in sales, leading to a rise in the USD.

Market pricing has now realigned with the Federal Open Market Committee's (FOMC) own rate projections, indicating three rate cuts for 2024.  As government bond yields continue to rise amid inflation surprises for the fourth consecutive day, discussions have surfaced regarding the upcoming dot plot next week, which may suggest only two rate cuts for the year. This poses a threat to risk-sensitive assets anticipating a swift shift from the Fed.

In the UK, data this week revealed that the economy had resumed growth in January after a slight recession in the latter half of 2023.  However, the GDP report has not significantly altered the outlook for UK rate cuts this year, especially after Tuesday's jobs report showed a deceleration in wage growth rates.  It is anticipated that the majority of the Monetary Policy Committee will vote to maintain the Bank Rate at 5.25% next Thursday. Nevertheless, persistent wage growth in the private sector and recent comments from MPC members suggest a potential three-way split in the vote.

The EUR is poised to finish the week stronger than most of its G10 counterparts, particularly against the NOK and SEK pairs amid inflation disappointments. Meanwhile, EUR/USD is expected to decline by approximately 0.6% on a weekly basis, marking its first weekly loss since mid-February.  EUR/USD is currently consolidating near a support level around $1.0880 (14-day SMA). With market sentiment turning negative overnight following disappointment from the People's Bank of China's (PBOC) lack of additional stimulus measures, the upcoming central bank meeting week is likely to commence with softer momentum across risk assets.

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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