Sterling under pressure as UK enters recession

Important calendar events

• Tertiary Industry Activity
• GBP: Retail Sales
• USD: PPI and Core PPI, Building Permits, Housing Starts, Preliminary UoM Consumer Sentiment, Preliminary UoM Inflation Expectations, Fed Monetary Policy Report

USD

The dollar retreated on Thursday, with the dollar index dropping to the 104.3 level. US treasury yields edged lower on Thursday, with the US 10-year bond yielding approximately 4.23%. 

US fundamentals will affect the dollar strongly in the weeks to come as these are likely to influence the Fed’s future policy. Weak US retail sales data on Thursday put pressure on the dollar. Retail sales dropped by 0.8% in January against expectations of a 0.2% drop and 0.4% growth in December. Core Retail sales, which exclude automobiles, shrank by 0.6% in January versus 0.2% growth anticipated and 0.4% growth in December.

US inflation surprised on the upside on Tuesday boosting the dollar. The dollar deflated towards the end of the week though, as markets had time to digest the news. US Headline inflation rose by 3.1% year-on-year in January from a 3.4% print in December against expectations of a much lower reading of 2.9%. Markets were anticipating a sharp drop in inflation in January, which was not realized, dashing expectations of early Fed rate cuts, and boosting the dollar. Monthly CPI rose by 0.3% in January, exceeding expectations of a 0.2% print. Core CPI, which excludes food and energy, rose by 0.4%, its higher monthly growth since June, against expectations of a 0.3% raise. Inflation in the US remains sticky and may put pressure on the Fed to keep interest rates at high levels for longer. Markets will now focus on US PPI data on Friday, to gauge the direction of US inflation.

Advance GDP for the final quarter of 2023 showed that the US economy expanded by 3.3% against the expectation of a more modest 2.0% growth. The US economy is expanding at a slower pace, as final GDP data have shown expansion by 4.9% in the third quarter of 2023, but economic growth in Q4 of 2023 exceeded expectations. Advance GDP Price Index for the final quarter of 2023 came in at 1.5% against expectations of 2.3% and a final print of 3.3% in the previous quarter. This is an indicator of inflation, and a lower print indicates cooling price pressures in the US.

The US Federal Reserve kept interest rates unchanged at its meeting in January, within a target range of 5.25% to 5.50%. The Fed, however, has removed the tightening bias from its policy statement, indicating that the central bank is preparing to pivot to a less restrictive monetary policy. The Fed’s outlook has become dovish, pushing the dollar and treasury yields down. Fed Chair Jerome Powell was quick to disabuse markets of the notion that rate cuts are imminent. In his press conference, Powell discounted the possibility of a rate cut in March. 

FOMC members’ opinions are starting to diverge, and we may see a battle of doves against hawks at the next policy meeting. For the first time, policymakers are discussing openly the possibility of rate cuts sometime this year. Even though most FOMC members agree that they are not yet ready to start reducing interest rates, markets are interpreting the change in rhetoric as a sign that the Fed is considering a pivot to a more dovish policy. 

Rate cut expectations have been fluctuating strongly in the past couple of weeks. Odds of a rate cut in March dropped to 10% after the release of the US inflation data, from over 50% two weeks ago. Rate cut odds in May are also down to 30% from over 80% a few weeks ago. In addition, only 25 basis points of rate cuts are priced in by May, against 25-50bp before. Market expectations of rate cuts are becoming more moderate as policymakers have stated that they intend to start reducing interest rates slowly. 

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EUR 

EUR/USD extended gains on Thursday, touching the 1.078 level as the dollar weakened. If the EUR/USD pair declines, it may find support at 1.065, while resistance may be encountered near 1.080.

The ECB kept interest rates unchanged at 4.50% as expected at its January meeting. The ECB press conference following the conclusion of the meeting did not hold many clues on the central bank’s policy direction. ECB President Christine Lagarde stated that interest rates are currently at sufficiently high levels to bring inflation down to the central bank’s 2% target over time. Lagarde also reiterated that ECB interest rates will remain at sufficiently restrictive levels for as long as necessary. 

Lagarde delivered a dovish testimony before the Committee on Economic and Monetary Affairs of the European Parliament, in Brussels, on Thursday. Lagarde stated that recent EU economic data pointed to inflation dropping to the ECB’s target, raising expectations of ECB rate cuts in the coming months. The ECB is expected to pivot to a more dovish policy later this year, but the timeline is still uncertain. 

Headline inflation in the EU came in at 2.8% year-on-year in January. Eurozone inflation dropped from 2.9% in December, although markets were anticipating an even lower 2.7% print. Core inflation, which excludes food and energy, cooled to 3.3% from 3.4% in December, which again was just above the 3.2% expected.

Eurozone fundamentals on Wednesday fell in line with expectations and did not affect EUR/USD significantly. EU employment rose by 0.3% in the final quarter of 2023 against expectations of 0.2% growth and by 1.3% year-on-year. Flash GDP data for Q4 of 2023 showed that the Euro area economy was stagnant with a GDP print of zero, as anticipated. The Eurozone economy does not show sufficient signs of recovery and is on the brink of recession. EU economy contracted by 0.1% in the third quarter of 2023 and barely expanded in the second quarter by 0.1%, after contracting by 0.1% in Q1. 

Economic sentiment in Germany and the Eurozone as a whole continued to climb according to data released on Tuesday. German ZEW Economic Sentiment, which is a leading indicator of economic health, rose to 19.9 in February from 15.2 in January against expectations of a 17.4 print. EU Economic Sentiment also exceeded expectations, climbing to 25.0 in February from 22.7 in January versus 20.1 predicted, as analysts are gaining more confidence in the economic outlook of the Eurozone. 

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GBP 

GBP/USD rose to the 1.260 level on Thursday as the dollar weakened. If the GBP/USD rate goes up, it may encounter resistance near 1.270, while support may be found near 1.250. Markets were quiet on Monday ahead of Tuesday’s US and Wednesday’s UK inflation data.

The British economy remains fragile and may force the BOE to pivot to a more dovish policy. British GDP data released on Thursday showed that the country has slipped into recession. Monthly GDP dropped by 0.1% in December, from a 0.2% growth in November, although market analysts were predicting an even larger drop by 0.2%. Preliminary quarterly GDP data revealed that the British economy contracted by 0.3% in the final quarter of 2023, against expectations of 0.1% contraction and 0.1% contraction in the third quarter of 2023. The British economy expanded by 0.3% in the first quarter of the year and 0.2% in the second quarter. 

British CPI data released on Wednesday showed that inflation in the UK was lower than expected. British headline inflation remained steady at 4.0% year-on-year in January, against expectations of a 4.1% print. Annual Core CPI, which excludes food and energy, grew at the same pace of 5.1% as December and November, against the 5.1% forecast. 

British inflation is expected to fall towards the BOE’s 2% goal in the coming months, relieving some pressure on the central bank to keep high-interest rates. The announcement of the British CPI data on Wednesday increased expectations of BOE rate cuts, boosting the Sterling.

Optimistic British labor data provided support for the Sterling on Tuesday. Claimant Count Change, which measures the change in the number of people claiming unemployment-related benefits in the UK, rose to 14.1K in January from 5.5K in December, which was lower, however, than the 15.2K anticipated. Average hourly earnings declined to 5.8% in the three months to December from a previous print of 6.7% but beat estimates of 5.6%. UK unemployment rate went down to 3.8 percent in the three months to December from 4.2% previously against expectations of a 4.0% reading. 

The BOE maintained its official rate at 5.25% at its latest meeting, as expected. MPC members, however, were more divided than ever. Six members voted to keep rates unchanged, two voted in favor of a 25bp rate hike and one member voted in favor of a 25bp rate cut. In addition, the BOE updated its inflation outlook, predicting that inflation will drop to the BOE’s 2% target in the second quarter of the year. This reinforced the notion that the central bank is preparing to cut interest rates. 

BOE Governor Andrew Bailey has stressed that inflationary pressures are cooling and that further rate hikes are not required. Market expectations of BOE rate cuts are putting pressure on Sterling. Markets had been pricing in aggressive rate cuts of over 100 basis points this year. In the past couple of weeks, however, rate cut expectations have become more moderate, dropping to 70bp. 

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JPY

USD/JPY edged lower on Thursday, dropping below the 150 level. If the USD/JPY pair declines, it may find support near 147.6. If the pair climbs, it may find resistance near 151.9.

The Yen gained strength on Thursday, even as the country fell into recession. Preliminary GDP data for the final quarter of the year showed that Japan's economy contracted by 0.1% against expectations of expansion by 0.2% and 0.7% contraction in the third quarter. The Japanese economy expanded by 1.2% in the second quarter of 2023, showing that the country’s economy is shrinking. Preliminary GDP Price Index data showed a 3.8% annual expansion in Q4, versus 5.0% in the previous quarter. This is a measure of inflation, which shows that inflationary pressures are dropping in Japan. Recession concerns and cooling inflation shrink the odds of a BOJ hawkish pivot in the coming months.

The Yen retreated to its lowest level in three months earlier in the week causing alarm among Japanese government officials. Japan’s top currency diplomat Masato Kanda stated on Wednesday that the government is monitoring excessive movements in the value of the Yen and will move to thwart opportunistic short sellers of the currency, hinting at another intervention to support the currency. The BOJ has intervened at least twice in 2022 to support the Yen by selling dollars and buying Yen to support the country’s currency. Japanese Finance Minister Shunichi Suzuki also mentioned that he is paying close attention to rapid movements in the currency, emphasizing that it is important for currencies to move stably reflecting fundamentals.

The BOJ kept all policy levers unchanged at its January meeting, maintaining its ultra-easy monetary policy. The BOJ has been keeping interest rates at a negative level, putting pressure on the Yen. The BOJ has so far maintained its dovish bias as other major central banks, and especially the Fed, have raised interest rates to high levels. 

BOJ Governor Kazuo Ueda has hinted at a policy shift down the road. Ueda stated that the likelihood of Japan sustainably achieving the bank's 2% inflation target was gradually increasing. Ueda has also stated that there is a high chance for easy monetary conditions to continue even after the central bank ends its negative interest rate policy.

An immediate policy shift is not expected yet, but markets are pricing in the first BOJ rate hike in April with over 50% probability. A rate hike by June is considered almost certain, with market odds giving over 90% probability of a shift in the BOJ’s monetary policy by June. Only a small rate hike of 10bps is considered likely, which would bring the BOJ’s interest level from negative to zero. 

Inflationary pressures are not sufficiently high in Japan to justify a shift to a more hawkish policy yet. National Core CPI data showed that Japanese inflation cooled further in December with headline inflation at 2.3% year-on-year from a 2.5% print in November. Tokyo Core CPI also dropped to 1.6% in January from 2.1% in December. 

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Written by:
Myrsini Giannouli

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