(Bloomberg) — Traders rushed to price more interest-rate cuts from the Bank of England this year after data showed UK inflation fell in December, easing fears over persistent price pressures that have rattled UK assets this year.
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For the full year, money markets now imply 50 basis points of reductions — two quarter-point moves — compared to fewer than 40 basis points on Tuesday. Gilts surged, paring a rise in yields that’s seen borrowing costs hit multi-decade highs and fueled concerns about the government’s fiscal plans. Stocks rose.
Still, the challenges for Chancellor Rachel Reeves remain in place, as highlighted by a 10-year bond sale on Wednesday where the borrowing cost of 4.81% was the highest since 2008. Traders also remain anxious that the respite may not last long as US inflation data due later Wednesday risks renewing a worldwide rise in yields.
“After a difficult start to the year, this morning’s inflation print will provide some relief to Chancellor Reeves,” said Zara Nokes, global market analyst at J.P. Morgan Asset Management. “We are not out of the woods yet, however, and the inflation dynamics could prove challenging this year.”
UK services inflation, watched closely by BOE officials, fell to 4.4% in December from 5% the previous month, a significantly larger drop than economists’ 4.8% forecast. Consumer price growth decelerated slightly to 2.5% from 2.6%, compared to the unchanged reading expected by economists.
UK’s Unexpected Inflation Slowdown Provides Respite for Reeves
While the pound initially slipped following the report as traders bet lower rates would dim its attractiveness, that move proved short-lived amid broad dollar weakness. The reversal also reflected a broader reappraisal of the UK outlook, given much of the currency’s recent weakness reflected a difficult mix of sticky price pressures and dim economic growth prospects.
“While weaker inflation typically weighs on a currency, these are not normal times for UK assets,” said Kathleen Brooks, research director at XTB. “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.”
The pound was little changed around $1.22 as of 1:13 p.m. in London. It is still down over 2% so far this year, by far the worst among major currencies.
The Debt Management Office’s sale of £4 billion ($4.9 billion) 10-year gilts saw yields jump some 48 basis points since the previous sale last month, reflecting the move higher in rates in secondary trading. The auction was oversubscribed 2.8 times, the lowest for that tenor since December 2023.
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By other metrics, though, demand was solid: the difference between the yield at the weighted average accepted price and the lowest accepted price, known as the tail, compressed to 0.9 basis points from 1.3 basis points at an auction last month. That suggests the UK needed to accept a smaller concession in pricing in order to sell the securities.
Gilts extended gains through Wednesday, pushing the 10-year yield as much as 10 basis points lower to 4.79%, and putting it on track for the biggest daily drop since October on a closing basis.
The UK has come under intense scrutiny as gilts emerged as the weakest link in a global government bond selloff last week due to concerns about sticky inflation, weak growth and the government’s ability to rein in its deficit. The rise in borrowing costs is eating into the little fiscal wiggle room Chancellor Reeves has left in her budget.
“The UK needs to come to a situation where it has fiscal sustainability, bond vigilantes in the UK are much stronger than they are in the US,” said Michael Strobaek, chief investment officer at Lombard Odier, on Bloomberg TV. “I am not quite certain as to whether politicians in the UK have understood the seriousness of this.”
What Bloomberg economists say…
“We think headline CPI will remain closer to 3% than 2% for the majority of 2025, and is likely to exceed 3% in some months. With another rise in household energy bills looming in the spring, it’s possible a move above 3% happens as early as April.”
— Dan Hanson, chief UK economist for Bloomberg Economics. See the full note here.
The recent volatility raised doubts on whether the BOE will decide to lower rates at next month’s meeting on Feb. 6. While traders are much more confident that a quarter-point cut is coming after Wednesday’s data — with the market-implied probability jumping to 80% from 60% on Wednesday — further pound weakness could derail policymakers’ plans.
Hedge funds were the main sellers of the pound on Wednesday, meeting modest corporate demand, according to two Europe-based traders familiar with the transactions who asked not to be identified because they aren’t authorized to speak publicly.
“It is too early to turn optimistic on a sterling rebound, but some recovery in the UK bond market is a necessary condition for preventing new major FX selloffs,” said Francesco Pesole, a currency strategist at ING Bank NV. “Still, looking a few months ahead, this CPI print points to BOE cuts that should allow sustained GBP depreciation.”
–With assistance from Vassilis Karamanis, James Hirai and Naomi Tajitsu.
(Updates prices.)
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