The much-anticipated US inflation report released yesterday failed to disrupt the prevailing market inertia. GBP/USD experienced a modest 0.4% fluctuation but closed the day lower, remaining within its 3-month trading range. Despite historically low realized volatility, the implied volatility in GBP crosses is currently at multi-year lows, indicating a lack of anticipation for increased market activity in the near future.

With the upcoming UK Spring Budget next Tuesday, market sentiments remain calm in contrast to the turmoil witnessed during the Liz Truss fiasco in October 2022. During that episode, implied volatility soared to levels comparable to those seen during the Brexit vote and the Covid shock, leading GBP/USD to hit a record low below $1.05. Subsequently, the pound experienced a recovery to over $1.30 (July 2023), a fall to $1.20 (October 2023), and has since stabilized within the $1.25-$1.28 range over the past three months. While this period of tranquility is atypical, it reinforces the GBP's appeal in high-yield carry trades.

As the UK fiscal event approaches next week, the prevailing question is whether it will disrupt the current stability. Usually, the GBP reacts minimally to such events; however, considering an impending UK election, the Chancellor might unveil a relatively substantial package of tax cuts despite the constraints posed by increasingly tight fiscal forecasts.

The EUR maintained its position above the $1.08 threshold as downward pressure on the US dollar from US PCE price figures and lower-than-expected German inflation data created an opportunity for the European Central Bank (ECB) to consider interest rate cuts starting in June.

Initial CPI reports from major European economies revealed a decline in Germany's inflation rate to 2.5% in February, below the market's anticipation of 2.6% and hitting the lowest level since mid-2021. Simultaneously, France experienced a decrease in its inflation rate to 2.9%, marking the lowest level since January 2022, while Spain recorded a six-month low of 2.8%, slightly surpassing market expectations of 2.7%. Despite recent positive inflation surprises, the ECB remains cautious, warning against premature declarations of victory over inflation.

ECB President Lagarde stressed on Monday the importance of additional evidence confirming that price growth is moving towards their target before considering monetary policy adjustments. Some Governing Council members are awaiting clearer wage growth data before endorsing a policy rate cut. Nevertheless, investors have revised upward their expectations for an ECB rate cut in June, with the probability rising to 79%, up from 73% at the beginning of the week. Overall, money markets anticipate a cumulative 91bps rate cut by year-end.

Yesterday marked the strongest daily performance for the USD in over a fortnight, driven by investors strategically positioning themselves ahead of eagerly awaited inflation data scheduled for release today. The initial weeks of the year have primarily witnessed investors adjusting their expectations, moving away from anticipating policy easing by central banks throughout 2024. The overarching trajectory of this trend hinges on the trajectory of inflation and growth, which must continue to defy expectations in a positive manner.

January's figures for both consumer and producer price inflation exceeded forecasts, registering a monthly growth rate of 0.3%. Attention now shifts to the pinnacle of the US macroeconomic calendar – the unveiling of the personal consumption expenditure index (PCE). The Federal Reserve's favoured metric for inflation is projected to exhibit an annualized decline, considering both headline and core growth rates. Despite the anticipated deceleration in the core PCE from 2.6% to 2.4% due to base effects, marking the twelfth consecutive slowdown in underlying price growth, a monthly surge of 0.4% is expected. This would signify the most robust monthly price increase in nearly a year. Given the Federal Reserve's emphasis on data-driven decision-making, this rebound could fortify the case for a conservative approach, possibly translating into just three rate cuts this year, with the first cut postponed well into the second quarter. Such a scenario might serve as a catalyst for short-term strengthening of the USD.

Monitoring various PCE indicators will provide insights into the breadth of inflation. The substantial gap between high core services (4.0%) and low core goods (-0.1%) inflation is likely to endure.

The euro showed a relatively stable performance against the US dollar, with the Greenback gaining strength amid a cautious market sentiment driven by mixed macroeconomic data releases from the US. In the early session, EUR/USD experienced gains due to a better-than-expected GfK print. However, it was unable to sustain these early gains and ultimately closed the day with minimal changes.

The GfK Consumer Climate Indicator revealed a slight improvement in German consumer morale for March compared to the 11-month low in February. Despite this, the headline index remained below its long-term average for the 28th consecutive time, marking the longest pessimistic streak. Income expectations reached their highest level since February 2022, while the propensity to buy and economic prospects remained relatively stable. Concurrently, the propensity to save reached its highest point since June 2008. This trend was mirrored across the Eurozone, where data indicated a notable slowdown in bank lending growth to nearly a 9-year low. This highlighted the significant deceleration in the bloc's economy due to the European Central Bank's unprecedented tightening measures implemented in recent months. Overall private sector credit growth, encompassing both households and non-financial corporations, remained at 0.4%, unchanged from the previous month.

EUR/HUF saw an increase of over 0.6%, reaching a 5-month high, as the National Bank of Hungary (NBH) executed an anticipated 100 basis points cut to its base rate, bringing it down to 9%. This move accelerated the rate-cutting pace following weaker-than-expected growth and benign inflation data since the January meeting. The euro maintained stability across most G10 pairs, with slight appreciation observed only against the Canadian dollar and the Swedish Krona. Looking ahead, investors will closely monitor today's Eurozone sentiment data for additional signs of a potential recovery in the Eurozone.

In spite of the general weakness observed in the US dollar, GBP/USD is encountering challenges in maintaining levels above $1.27, largely due to investors scaling back their optimistic positions on the pound after eight consecutive weeks. The 3-month implied volatility for GBP/USD has reached a four-year low, indicative of investor complacency and the currency's consistent performance.

The subdued atmosphere in the foreign exchange market has heightened the popularity of carry trades, benefiting the pound as a higher-yielding currency. This trend has been supported by the hawkish reassessment of UK interest rate expectations. While the assumption that the Bank of England (BoE) will delay interest rate cuts compared to the Federal Reserve and the European Central Bank (ECB) has favored the pound in recent months, the sustainability of this advantage is uncertain. Money markets are currently pricing in fewer than three rate cuts by the BoE before the year-end, a significant reduction from initial expectations at the beginning of the year.

On the economic front, we believe that the UK has already exited its technical recession, and the potential for a faster decline in inflation increases the likelihood of a consumer-driven recovery in UK GDP growth in 2024.

Although this week's UK data docket is relatively quiet, the Confederation of British Industry's monthly retail sales balance, a measure of sales compared to a year ago, showed improvement, rising to -7 in February from -50 in January—the slowest decline in 10 months. Despite this, the pound is experiencing a decline across various currency pairs, with GBP/EUR slipping back below the €1.17 threshold.

Yesterday's stronger-than-expected UK PMIs indicate that the technical recession in the UK may already be over. Private sector output in the UK expanded for the fourth consecutive month, reaching its fastest pace since May 2023. The robust performance is driven by a strong service sector (PMI of 54.3), outperforming the Eurozone (PMI of 50). Although GBP/EUR remains below the €1.17 mark, GBP/USD is holding above $1.26, rebounding from a three-week high above $1.27, marking a potentially strong week for the currency pair in 2024.