The primary factor influencing market pricing and the GBP's short-term outlook is the UK inflation report due on Wednesday. Consensus expectations suggest that the headline CPI will decrease from 3.2% to just above the Bank of England’s (BoE) 2% target. This could limit GBP’s upward momentum if traders focus on weakening rate differentials rather than the improving growth outlook.

The report’s outcome could either trigger the beginning of an interest rate-cutting cycle at the BoE next month, which would be negative for GBP, or signal to policymakers that the battle against inflation is not over, which would be positive for GBP.

Notably, the services component of the inflation basket is likely to generate the biggest market reaction, as the BoE has emphasized its focus on this area. Deputy Governor Ben Broadbent highlighted on May 9th that he will scrutinize services inflation more closely than wages in the short term.

The GBP/EUR exchange rate has trended higher in recent days, comfortably returning to the middle of the 2024 range. Although the pair is still down for May, last week's recovery has improved the technical outlook, and a retest of 1.17 could occur in the coming days. However, significant movement is unlikely before Wednesday’s UK inflation data release. It is possible that GBP/EUR may slip earlier in the week as investors reduce exposure ahead of the report.

Against the USD, GBP recorded its second-best weekly advance of 2024, hovering at six-week highs around GBP/USD 1.27. Signs of cooling US inflation and a weakening US economy have increased the likelihood of Federal Reserve rate cuts, exerting pressure on the USD.

The USD index rebounded from 5-week lows yesterday, buoyed by data showing a 0.9% increase in US import prices last month. This data tempered some of the optimism about US disinflation and potential Federal Reserve (Fed) rate cuts that had emerged earlier in the week. Despite this rebound, following a slightly softer CPI report and signs of a cooling US economy and job market, the USD is on track for a weekly loss and is experiencing its worst month of 2024.

The slowdown in consumer prices led markets to anticipate that the Fed might cut rates twice this year, with the first cut possibly coming as early as September. However, concerns are resurfacing as import and export prices rose more than expected, alongside a surprise increase in producer prices earlier in the week. This suggests that inflation is moderating above the Fed’s 2% target, which could delay plans for rate cuts and potentially keep the USD stronger for a longer period.

The recent aggressive sell-off in the USD highlights our ongoing theory of its asymmetric reaction to incoming data—falling more on data misses than rising on data beats. However, we believe the market overreacted this week, as reflected in the dollar’s modest bounce-back yesterday.

The euro surged to nearly a five-week peak of $1.0826, marking its strongest performance in over a week, as demand for the dollar eased despite uncertainties surrounding US PPI data, deepening speculation on the Fed's rate cut trajectory. European stock indices remained steady, with investors awaiting the April US CPI figures for further guidance.

Internally, the latest ZEW survey revealed encouraging signs, suggesting that the worst of the economic downturn in the region may be over. Germany's ZEW investor sentiment index soared to 47.1 in May, supported by rising real incomes, improved domestic consumption, and recovering export demand. While this marks the gauge's tenth consecutive monthly increase and its highest level since February 2022, the current component of the ZEW remains subdued, underscoring lingering growth risks as the industrial sector struggles to rebound. Expectations of a June ECB rate cut continue to drive optimism, with ECB's Knot reiterating the possibility of monetary easing at the upcoming meeting, echoing sentiments expressed by Fed's Powell at the Annual FBA meeting.

EUR/USD breached its 200-day SMA following the release of higher-than-expected US PPI data, injecting much-needed volatility into the market. The pair is now eyeing its 100-day SMA around $1.0826, with overnight option implied volatility reaching a 14-month high of 12.85%. A further uptick in volatility could propel euro bulls towards $1.0900, signaling a break from the bearish trend observed since March. Investors are adjusting their positions in anticipation of a stronger euro, reflected in the most bullish 1-week EUR/USD risk reversals since February, as expectations of softer US inflation align monetary policy outlooks on both sides of the Atlantic. Hedge funds have significantly reduced their short positions on the euro by approximately 40% over the past month, according to the latest CFTC data. As of now, the implied probability of an ECB rate cut next month remains steady at around 95%, with markets pricing in 68 basis points of cuts by year-end, compared to the Fed's projection of 54 basis points.