Shock inflation figures dents Sterling

Pound Sterling (GBP) today weakened against the Euro (EUR) and the U.S. Dollar (USD) due to position adjustments ahead of the UK inflation data. Later in the session, the Dollar also regained strength. The GBP/USD exchange rate dipped close to the 1.3000 level before stabilizing, while the GBP/EUR exchange rate retreated near 1.1600.

On Wednesday, the Pound experienced a significant decline following weaker-than-expected inflation data. The GBP/USD pair slid to one-week lows near 1.2930, and the GBP/EUR pair declined to seven-week lows at 1.1525 before attempting to stabilize. This led to a shift in money-market pricing, with the chances of a further 50 basis-point hike declining from 65% to around 35% compared to earlier in the week.

Expectations regarding the Bank of England (BoE) also shifted, with the projected peak interest rates now around 5.8%, down from around 6.0% on Tuesday and 6.5% earlier in the month.

The UK inflation data for June came in below expectations, which could potentially weaken the British Pound. The year-on-year inflation rate measured 7.9%, down from 8.7% previously, while the core CPI (Consumer Price Index) was 6.9%, down from 7.1%. Forecasts had anticipated a rise of 8.2% y/y for CPI and for core inflation to remain at 7.1% y/y.

The Office for National Statistics (ONS) reported that CPI inflation only increased by 0.1% month-on-month in June, falling short of the market's expectation of 0.4% and a significant decrease compared to May's 0.7% rise. Core inflation rose by 0.2% m/m in June, half of the expected 0.4% and lower than the 0.8% reported the previous month.

This undershoot in inflation led to reduced expectations for future interest rate hikes by the Bank of England, which subsequently impacted UK bond yields and the value of the Pound. Initial responses from economists suggest that the Bank of England will now raise interest rates by only 25 basis points in August, compared to the market consensus of a 50 basis-point hike.

Consequently, the market is expected to adjust its expectations, leading to lower UK bond yields and a weaker Pound.

Throughout 2023, the UK currency had been rallying due to more resilient-than-expected inflation and a more assertive monetary policy stance from the Bank of England, including interest rate hikes and revised guidance. However, the recent fall in inflation is likely to result in a weaker Pound, while also improving the longer-term economic outlook by relieving pressure on households and businesses.

The Office for National Statistics attributed the decrease in inflation to declines in transport prices, particularly motor fuels, as well as notable downward effects from food and non-alcoholic beverages, furniture and household goods, and restaurants and hotels. There were no significant upward effects to counterbalance these declines.

Regarding the future outlook for UK inflation, the Bank of England will take into consideration the deflationary pipeline for goods inflation. Factory output prices fell by 0.3% m/m in June, with May's figure revised lower to -0.6%. Factory input inflation stood at -1.3% m/m, lower than May's -1.2%.

Although external inflationary pressures are easing, domestic price pressures are expected to remain relatively high due to wage increases in the UK, which have reached multi-year highs. In May, the average earnings index, excluding bonuses, rose by 7.3%. Consequently, the Bank of England is likely to remain vigilant and proceed with another rate hike in August.

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