Pound stages recovery

Good news on UK inflation boosts the pound

There was a positive surprise for UK inflation after a bruising start to the year for UK asset markets. Inflation in the UK moderated in December, the headline rate was 2.5%, below expectations for a 2.6% rate. The core rate also moderated to 3.2% from 3.5% and the all-important service price gauge also moderated to 4.4% from 5%.

Breaking down the inflation report: where will prices go next?

The initial reaction to this report is one of relief, this could ease the upward pressure on UK bond yields, and it may assuage fears about UK growth, as it suggests that there is less pressure on the consumer. However, there are two other factors to consider alongside this report, which may limit the room for recovery. 1, the hike in national insurance included in the Labour budget will come into force in April. Big retailers and hospitality names have said that they will pass on cost increases to consumers in the coming months. Added to this, energy price hikes will feed into the January figure, so the moderation in inflation could be short lived. 2, This inflation report could be a sign of a fragile economy. The sharper than expected decline in the pace of service price growth could suggest a rapid weakening of the economy and a softening of the labour market.  Service prices have been rising on the back of strong wage growth and companies building their margins. If businesses feel like they can’t boost their margins with price increases anymore, then it could be a sign of weak demand.

GBP/USD stages mini recovery

The direction for GBP/USD this morning is higher. Cable is attempting to regain the $1.22 level. While weaker inflation typically weighs on a currency, these are not normal times for UK assets. The pound may stage a short-term relief rally on the back of this report because some of the upward pressure on yields has been driven by fears about stagflation. These fears have partly eased this week, which could help the pound to stabilize from here.

What the BOE does next

This report pretty much guarantees a rate cut from the BOE next month, the market is currently pricing in an 85% chance of a cut. There are now two interest rate cuts fully priced in for the BOE this year, earlier this week there were less than two cuts expected. This is also adding to the relief rally in UK assets, including the pound and UK bonds. The moderation in UK inflation is closer to BOE forecasts, and this supports further rate cuts throughout this year. European yields are falling on Wednesday, and we expect the UK to follow suit. If there is a short-term recovery in UK yields, then the focus may shift to France, which has a larger budget deficit than the UK and it still does not have a budget for 2025.

The market has had a strong reaction to this report, however there are more tests ahead in January. Thursday’s GDP data for November and the latest public sector finances that are due later in January, will all be scrutinized by the bond market vigilantes. The market still has a distaste for Reeves’ spending plans, and it does not like the UK’s structural current account deficit, which may put a cap on the recovery in the pound and in UK bond yields.  The pressure on Rachel Reeves is likely to continue as the market forces the chancellor to reassess her plans for public spending.

UK bond auction in focus

The CPI data for the UK comes before today’s latest bond auction. The Treasury is aiming to sell 10-year bonds. The last 10-year auction saw a solid bid-to-cover ratio of 2.87 times, and a yield of 4.22%. This bond auction is not linked to inflation, so the recent surge in yields could add to fears about the substantiality of the government’s finances and their ability to meet their spending needs.

US inflation preview

Ahead today we also get US CPI for December. The market is expecting another move higher in prices, with headline CPI expected to jump to 2.9% from 2.7% in November. The monthly rate is also expected to rise by a hefty 0.4%. The core rate is expected to remain stable at 3.3%. After trending down for most of 2023 and 2024, US disinflation has plateaued, and this is worrying for investors. Compounding these concerns are fears about the US economy overheating under Donald Trump. Growth already remains strong, and his administration is expected to extend tax cuts, slash regulation and boost tariffs, which may increase inflation further in the coming months.

A strong labour market is adding to concerns that inflation could take hold once more, and if we get an upside surprise in today’s CPI report, then it could boost fears that rising inflation will wreak havoc on markets in 2025. Stocks have already had a weak start to 2025. The main US indices are all lower so far, and the Nasdaq is down by more than 1.1%. US bond yields may have stabilized in recent days, but the 10-year Treasury yield is still higher by 21 bps year to date. The market is focused on the 10-year Treasury yield as it approaches 5%. The 10-year yield is currently at 4.78%, however, a strong CPI reading could be a steppingstone to breaching the 5% level, which holds psychological significance for investors. If the Treasury market does breach this level, then it could weigh further on stocks and overall risk sentiment. It could also seep into global bond markets and push up yields in the UK and Europe. Thus, a lot is resting on today’s US CPI report. It could also determine, what the Fed does next. There is only 1 rate cut currently priced in for the Federal Reserve for this year. A strong CPI reading could see this cut also get priced out, which may add to stress in financial markets.

US bank earnings expected to report mega trade flows after Trump’s election win

On top of the economic data due today, the market will also be focused on bank earnings. JP Morgan, Goldman Sachs, Morgan Stanley, and Bank of America all report their results this week, with JP Morgan, the US’s largest bank, reporting Q4 earnings at 12.30pm GMT today. The market is expecting the largest US banks to report a windfall in trading revenues on the back of Donald Trump’s election victory, which triggered a large rally in equity markets and other assets. Wall Street banks are expected to report an average 15% increase in trading revenues for last quarter, which could top $24.5bn. Looking ahead, there could be elevated volatility in 2025, which could also keep trading revenues high. If Wall Street’s largest investment banks do report strong earnings, then this could be good news for Barclays in the UK, since it is one of the few UK banks with a large IB arm.

Investors will also be looking at US banks’ net interest income. This could be a weak spot for earnings in Q4, and NII is expected to fall in Q4 2024 vs. a year earlier. However, with Fed rate cuts getting priced out of the market, NII could stabilize going forward. Overall, we are expecting a strong set of bank earnings. Of course, the impact on the banks’ stock prices will depend on their future outlooks. While there are concerns that the US economy could overheat, a stabilization in NII along with continued market volatility could lead to favorable outlooks for the months ahead. The KBW US banking index has fallen more than 8% since peaking in late November. These earnings will be a key driver of whether US bank stocks can recover in the medium term.