British pound slips after sharp fall in UK inflation

British pound declines as annual UK CPI slows to lowest pace since September 2021

Pound sterling declined against both the U.S. dollar and euro following the release of data revealing a drop in British inflation for November, coming in significantly below expectations.

The news prompted financial markets to revise projections for when the Bank of England (BoE) might begin cutting interest rates next year.

Following the announcement by the UK’s Office of National Statistics (ONS), the pound to dollar rate was down by 0.56% at $1.2659, compared to a marginal decline of around 0.15% just before the data was released. It also weakened against the euro, which saw an increase of 0.43% at 86.62 pence.

Annual consumer price inflation in the UK dropped to 3.9% in November from the previous month's 4.6%, marking the slowest pace since September 2021. This figure fell below all forecasts for the Consumer Prices Index (CPI) in a Reuters poll of economists, which had anticipated a rate of 4.4%. Core inflation also experienced an unexpectedly significant drop, declining from 5.7% to 5.1%.

Some economists, such as PwC’s Jake Finney, are of the opinion that there is “strong evidence” that longer-run price pressures are recendingreceding. Reuters quoted Finney as saying:

"[The November CPI reading] provides strong evidence that disinflationary pressures are building in the UK. Headline, core and services inflation are all now materially below the Bank of England's expectations in their last November Monetary Policy Report."

The lower-than-expected inflation data led the market to adjust its expectations for Bank of England interest rate cuts. There is now full pricing for a 25-basis-point cut by May 2024, with nearly a 50% chance of such a cut occurring by March.

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UK interest rates: ING says BoE may now be perceived more hawkish than Fed, ECB

In a response to the announcement of the UK CPI reading, ING’s Developed Markets Economist James Smith said that markets may be overestimating the likelihood of rate cuts starting in May. The bank forecasts the BoE to begin scaling back borrowing costs in August 2024:

“[...] We think markets are right to be pricing a number of rate cuts for 2024. Investors now expect 140bp of cuts in 2024 after this latest downside surprise on inflation, starting in May. That’s maybe pushing it, and we still think the Bank will prefer to tread a little more cautiously with 100bp of cuts starting in August.

But interestingly, this data has also seen investors reassess where the BoE stands relative to the Fed and European Central Bank. Up until now, markets had been expecting both of the latter to be much more aggressive than the BoE, but that narrative seems to be fading”.

GBPUSD forecast: Citibank HK bearish on pound to dollar rate

The pound to dollar forecast issued by economists at Japan’s MUFG bank said that GBP would remain “pressured to the downside” for the foreseeable future. The forecast didn’t provide explicit GBPUSD projections for any timeframe:

“The sharp drop in the YoY headline CPI rate from 4.6% to 3.9% (expected at 4.3%) in November will be very welcomed by the BoE. The weakness looks broad-based as well with the core YoY rate 0.5ppt weaker than expected at 5.1%, down from 5.7%, helped by weaker services CPI which fell from 6.6% to 6.3% – the market expected it to remain unchanged.

The scale of the downside surprise in today’s CPI will likely prove telling, possibly not immediately, but as we proceed through Q1 next year. Before today, the OIS market implied the first rate cut would be in June. That is likely to be brought forward now and lower yields will keep GBP pressured to the downside for now.

The market view of divergence of the BoE relative to the Fed and the ECB has been undermined by this CPI report but wages will need to show some big downside surprises too to prompt a big dovish shift from the BoE”.

EURGBP forecast: Danske Bank sees sterling weakening against euro in 12-month range

In an updated euro to GBP forecast issued on December 15, Danske Bank associate Mohamad Al-Saraf wrote that pound sterling may weaken against the common currency in the next 6 to 12 months, potentially reaching the 0.89 mark:

“Over the past month, EUR/GBP has moved lower following a sharp repricing of both the ECB which has meant an increasing divergence to BoE pricing. The cross is currently trading just above the 0.86 mark. The past week, the cross has slowly edged higher. Overall, we expect the UK economy to perform relatively worse than the euro area and expect relative growth outlooks and central bank pricing to weigh on GBP. We target the cross at 0.89 in 6-12M".

UK inflation rate: Gilts drop, stocks rally respond to CPI slowdown

The markets perceiving the Bank of England's monetary policy stance as hawkish, compared to other major central banks, had supported the strength of the British pound in previous weeks. The revised expectations, however, have prompted a rally in British shares and government bonds (known as gilts).

Britain's 10-year yield decreased by 10 basis points to 3.55%, and the rate-sensitive two-year yield fell by 17 bps. Both the blue-chip FTSE100 index and FTSE250 stock index in Britain rose over 1%, reaching their highest levels since May.

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