The UK yield curve has disinverted for the first time since May 2023 and is expected to steepen further as traders anticipate the Bank of England (BoE) will soon start cutting interest rates, with more reductions likely over the next year. Recently, sterling has been influenced by broader market sentiment, dropping below $1.29 against the US dollar last week. The focus now shifts to the BoE meeting this Thursday to see if the pound can make another attempt at $1.30.

The decision on whether the BoE will cut rates this week remains uncertain. Expectations for a rate cut increased significantly after the June meeting, where policymakers revealed that the decision to hold rates was “finely balanced,” with two members voting for a cut. Since then, a new government has taken office, and the latest PMI readings indicate that cost pressures are easing, driven by decreasing output prices in the services sector, which has been a significant contributor to consumer inflation. Despite slight increases in services inflation and private sector wages, along with strong survey results, we believe the market may be underestimating the likelihood of a rate cut this Thursday. This could expose the pound to short-term downside risk.

Nevertheless, the stronger UK economic recovery, improving consumer confidence, and the UK’s renewed engagement with the EU are all positive factors for the pound. As a result, our long-term outlook for GBP remains bullish.

The Pound to Euro exchange rate fell last week, as our previous Week Ahead Forecast predicted. We expect this pressure to continue leading up to Thursday's crucial decision from the Bank of England.

Over the past two weeks, GBP/EUR has declined from its 2024 highs. However, we see this weakness as part of a broader uptrend, with the overall outlook remaining positive. The exchange rate is still well above its 50-, 100-, and 200-day moving averages, and only when these levels are breached would we consider the uptrend at risk.

In the coming weeks, we anticipate a potential test of 1.20 (see forecasts from over 30 investment banks for Q3 and year-end). In the short term, we expect more room for weakness, with a test of 1.18 likely before the rally resumes. Last week, the exchange rate fell below the 21-day moving average, which is now limiting intra-day advances (currently at 1.1854), supporting our expectation of pre-Bank of England nerves pushing the rate down.

The Pound is experiencing crowded positioning, with many investors betting on further advances. This heavy one-way positioning means any disappointments in data or events could trigger a significant 'washout' and a deeper pullback.

Currently, markets see slightly more than a 50% chance of a rate cut on Thursday. Last week's weakness in the Pound reflects these recalibrated expectations, as the odds of a cut were closer to 40%.

If the Bank of England does not cut interest rates, it could provide some relief to the Pound, allowing for a rebound by the end of the week. However, a firm commitment to a September rate cut would create a 'dovish' hold, which might not support a strong rebound in the Pound.

Overall, we expect near-term weakness to give way to a resumption of the rally in the coming weeks.

The risk-off sentiment in global financial markets this week has impacted Bank of England (BoE) policy expectations. The likelihood of a BoE rate cut in August has risen above 50%, pushing the 2-year gilt yield below 4%, reaching a new one-year low. Consequently, the pound is on track for its second consecutive weekly loss against the US dollar, hovering near its critical 200-week moving average around $1.2850.

Similar to the dollar, the pound's largest weekly declines have been against safe-haven currencies like the Swiss franc and Japanese yen, with the latter dropping almost 3% this week—its worst performance since the UK mini-budget crisis in late 2022. GBP/EUR is also set for a second weekly decline, retreating further from nearly two-year highs above €1.19. Given the pound's vulnerability against these major currencies, we believe markets might be underestimating the chances of UK rate cuts this year. Whether the first move happens in August or September remains uncertain, and with 1-week GBP/USD implied volatility at a one-month high, markets are bracing for a tense BoE meeting next week.

However, if the BoE issues a hawkish cut or maintains rates, emphasizing the persistent inflation risks, we could see GBP/USD and GBP/EUR rebound towards $1.30 and €1.20, respectively. This outcome, though, will also depend on broader global market conditions, as evidenced this week.

On Wednesday, the US dollar index experienced its largest daily drop in five sessions, primarily due to the ongoing strength of the Japanese yen. This surge in the yen is attributed to unwinding carry trades, safe haven flows, and increasing expectations of a rate hike in Japan following a significant rebound in Japanese private sector activity.

The yen appreciated to over 153 per dollar, its highest level in more than two months, compelling short-sellers to exit their positions. Since mid-July, the yen has strengthened by over 5% against the dollar, a movement initially sparked by suspected government intervention. Meanwhile, market risk sentiment deteriorated further as the tech-heavy Nasdaq 100 fell, prompted by a series of disappointing earnings from major European companies, which increased demand for safe havens like the yen, Swiss franc, and gold. In the US, the composite PMI rose to 55.0 in July from 54.8 in June, the highest since April 2022, indicating continuous growth over the past 18 months, with the service sector outperforming manufacturing for the fourth consecutive month. Despite this growth, employment slowed and business confidence declined due to rising political uncertainty.

The yen's rally and its potential for a significant reversal hinge on upcoming monetary policy decisions by the Bank of Japan and the Federal Reserve on July 31. While no changes to US interest rates are expected, the 2-year Treasury yield fell below 4.40% for the first time since February after New York Fed President Bill Dudley indicated that economic conditions might justify a rate cut. The first rate cut is still anticipated in September, in line with market expectations. In contrast, the likelihood of a rate hike in Japan has surged from 45% to over 80% this week, maintaining strong demand for the yen.