Pound under pressure despite hotter inflation

Sterling initially firmed on Wednesday after UK inflation surprised to the upside, but gains quickly faded as markets weighed the stagflationary backdrop. GBP/USD struggled to hold above $1.35, while GBP/EUR hovered around €1.16, underscoring how fragile the currency’s yield-driven rally has become.

Headline inflation accelerated to 3.8 per cent in July, the highest level since January and above consensus expectations of 3.7 per cent. Transport costs were the main driver, with airfares surging more than 30 per cent and pushing overall transport inflation to 3.2 per cent, up sharply from 1.7 per cent the month before.

Perhaps more troubling for the Bank of England was the resurgence of services inflation to 5 per cent, alongside a broadening in price pressures across the CPI basket. Over 40 per cent of components are now running above 4 per cent, with more than 20 per cent above 6 per cent — a stark shift from last year, when no category exceeded that threshold.

The data raise awkward questions about whether the Bank acted too soon in cutting rates earlier this month. Market pricing for another reduction before year-end has already been pared back, with the probability of a cut by December falling to roughly 42 per cent from around 50 per cent only yesterday. Even with policy likely to remain on hold, fiscal and growth concerns continue to cap sterling’s upside potential.

Dollar steadies as AI optimism cools

Across the Atlantic, the US dollar has found some short-term stability, rising around 0.5 per cent against a basket of peers so far this week. The move comes amid a sharp correction in technology stocks, with Nvidia falling 3.5 per cent on Tuesday and dragging the Nasdaq Composite down 1.4 per cent, its second-worst session since April’s tariff shock. Investors are questioning whether enthusiasm around artificial intelligence has become excessive, tempering the tech-led equity rally.

Despite a difficult first half of the year, the dollar’s weakness has often been overstated. Friday’s TIC data revealed foreign holdings of US Treasuries hit a record high in June, contradicting the “sell America” narrative fuelled by political uncertainty. Meanwhile, volatility remains subdued, credit spreads tight, and emerging markets continue to attract inflows — suggesting investors are still broadly constructive on risk.

Geopolitics adds a layer of cautious optimism. Recent summits have raised hopes of progress towards peace in Ukraine, though the most sensitive territorial issues remain unresolved. If energy markets stabilise, sentiment across Europe and emerging markets could lift further.

The dollar’s rebound is unlikely to last if the Federal Reserve minutes, released later today, show greater support for rate cuts. Markets continue to anticipate two or three reductions this year, with Jackson Hole later this week looming as a potential trigger. Last year Chair Powell used the symposium to prepare markets for a significant policy shift — even a subtle signal this time could reset USD positioning.

Euro marking time

The euro remains in a tight range, with EUR/USD moving less than 0.5 per cent in either direction in recent sessions. Despite being up 12 per cent year-to-date, upside momentum has faded, with the pair pinned near its 21- and 50-day moving averages.

Thursday’s eurozone PMI releases will be critical for gauging whether business confidence is eroding in the wake of the new US–EU trade agreement. The August ZEW survey already raised red flags: German economic sentiment plunged 18 points to 34.7, while the current conditions index fell to -68.6, both well below expectations. Weak Q2 growth in core sectors such as chemicals, autos, and engineering compounds the gloom.

While volatility is low and EUR/USD remains rangebound, a downside surprise in PMIs could shift sentiment towards caution. That said, the longer-term case for the euro remains intact. Growth differentials are once again becoming central drivers, with Europe’s downturn proving shallower than feared and fresh fiscal stimulus expected to support GDP from late 2025. By contrast, US resilience may fade as the year progresses. This evolving divergence could reassert itself as a source of euro strength in the quarters ahead.