UK Inflation: Prices Peak Compared to Peers

UK inflation running above U.S. and Eurozone levels reflects both structural pressures, like supply constraints in food, energy, and transport, and cyclical factors, such as seasonal air travel. For markets, this divergence could have several effects: it could weigh on equities - especially domestic-focused sectors. It could lead investors to expect fewer Bank of England (BoE) rate cuts relative to other central banks, keeping interest rates higher for longer.

Looking ahead, the International Monetary Fund (IMF) projects UK inflation to decrease to 2.3% by 2026, assuming that current inflationary trends are temporary. However, with persistent price increases in essential sectors like food and energy, the BoE faces a difficult balancing act: it must manage inflation without further slowing an economy that is already struggling, with recent headline GDP figures showing only modest growth.

Market reactions were swift and indicative of investor concerns over persistent price pressures:

• Bond Markets: UK two-year gilt yields (which move inversely to prices) surged to nearly 4%, marking a two-month high. This spike reflects market expectations that the BoE may delay further interest rate cuts.
• UK equities: Stocks ticked down, after a period of strong performance. This dip can be attributed to investor caution, as concerns over sustained inflation and its impact on consumer spending and corporate profitability weighed on market sentiment.
• Currency: The British pound saw a modest weakening against major currencies. This depreciation reflects investor apprehension about the UK's economic outlook.

Overall, the July inflation data underscores the UK’s ongoing price pressures, highlighting the delicate balancing act facing the BoE and the cautious stance of markets as investors adjust to a slower-growing economy with persistently high costs.

The Noise

• In equity markets this week we saw a sell-off in US stocks off driven by negative news flow around AI, falling around 1%. To put this in context, whilst US markets fell for four consecutive days, they were cooling off from hitting all-time highs the week prior. So, the pullback looks more like a healthy cooling-off, following a ferocious recovery from mid-April lows.

• In bond markets this week, US 30-year Treasury yields (which move inversely to prices) ticked 0.07% higher as stronger inflation numbers and solid economic data made investors less confident that the Fed will cut rates soon. The U.S. Treasury also bought back $4 billion of its own debt, a move that raised questions about how easily bonds can trade in today’s market. Corporate bonds, however, stayed in demand, with investors willing to pay up for extra yield compared to safer government debt.

• In currency markets, we saw the US dollar appreciate by 0.9% this week, ending its two-week losing streak according to the dollar index, which measures the currency’s values against a basket of developed economy peers. This was driven by markets dialling back expectations for an imminent Fed rate cut due to recent economic data and comments from Fed officials. The probability of a 25-basis-point interest rate cut in September fell from about 92% at the start of the week to roughly 75% now. This recalibration supported broader demand for the US dollar and pushed the dollar index higher. Yet this small uptick hasn’t unwound the structural weakening we have seen this year, with the dollar index still down 8.9% year to date.

The Niche

At roughly 0.1 mm thick, if you stacked all UK banknotes in circulation, the pile would reach over 500 km high - well into space, almost beyond the orbit of the International Space Station!