Inflation concerns linger as UK stocks, bonds, and currency continue to decline

According to the Zhitong Finance APP, UK asset prices fell again on Monday, and anxiety ahead of key inflation data may lead to a continuation of the sell-off in the UK market. The British pound was the worst-performing G10 currency on Monday, with the pound falling 0.8% against the US dollar to 1 pound to 1.2106 dollars, the lowest level since November 2023. UK government bonds also declined, with the yield on 10-year UK government bonds returning to last week's high of 4.92%, the highest level since the global financial crisis in 2008. The UK stock market was also hit, with the FTSE 250 index experiencing its worst weekly performance since June 2023. As of the time of writing, the FTSE 250 index was down nearly 0.3%.

These trends indicate that UK assets will remain fragile at least until the UK December CPI data is released on Wednesday. Although global bonds have performed poorly since early December last year, the performance of UK government bonds has been particularly weak due to investors' concerns about persistently high inflation and tight public finances in the UK.

Lee Hardman, a senior foreign exchange strategist at MUFG, stated: “In the current market environment, the continued sell-off of UK government bonds is raising more concerns among market participants about the UK government's fiscal situation, and even a stronger UK inflation report may have a more negative impact on the pound.”

Economists predict that the year-on-year increase in the UK December CPI will remain at 2.6%, still above the Bank of England's target of 2%. Signs of renewed price pressures could trigger further market volatility.

Meanwhile, options trading indicates that the weakness of the pound will continue. A one-month risk reversal indicator measuring market sentiment shows that traders' attitudes towards the pound are the most pessimistic since December 2022. Additionally, the cost of hedging pound volatility over the next month has risen to its highest level since March 2023.

Bob Savage, head of market strategy and insights at a New York bank, stated: “UK economic data may bring a theme in 2025—‘new stagflation,’ where fiscal and monetary policies exacerbate growth, leading to a stagnation of the anti-inflation process.”

Investors will also closely monitor the sale of 30-year UK inflation-linked bonds on Tuesday and the sale of 10-year UK government bonds on Wednesday. Last week, a long-term bond sale recorded the lowest oversubscription level since 2023, while the new 5-year government bonds received strong demand.

Economists issue a 3% inflation warning

Economists warn that the UK inflation rate will exceed 3% this spring. The Bank of England may face a new battle to reassure investors about its commitment to interest rate cuts.

By 2025, energy bills will again become a larger factor driving price increases, according to Andrew Goodwin, chief UK economist at Oxford Economics, who stated, “We have already believed that inflation this year will be higher than the Bank of England's estimates, but the recent rise in energy prices means that the inflation rate may be even higher.” He expects inflation to peak at 3.3% in the third quarter.

Against the backdrop of a turbulent global economy, Bank of England Governor Andrew Bailey and other rate setters face another difficult trade-off. Officials may become more forward-looking, focusing on the economic growth outlook despite the possibility of a temporary rise in inflation, while the recent surge in UK government bond yields only weakens the economic growth outlook. Alternatively, the Bank of England could continue to focus on the deteriorating inflation situation and adopt a very cautious approach to interest rate cuts.

Dan Hanson, Chief UK Economist at Bloomberg Economics, stated: "The broader issue facing the Bank of England is what they will focus on in the coming year if inflation is above target and unemployment rises." "Recent inflation events tell us that inflation expectations can be volatile," he added. "This means that if the Bank of England faces the same trade-offs as before the pandemic, it is unlikely to support the economy as vigorously as it did previously. The result will be a struggle to escape gradual interest rate cuts."

Is the pound about to drop another 8%?

Options market traders are bracing for a scenario where the pound drops another 8%, as the fiscal turmoil that triggered painful sell-offs in the UK market last week has put pressure on the pound. According to data from the Depository Trust & Clearing Corporation (DTCC), there is significant demand for contracts betting on the pound falling below 1.20 against the dollar, nearly 2% lower than last Friday's trading price. Some traders are even betting on the pound/dollar price dropping below 1.12, the lowest level in over two years.

Jamie Niven, a fund manager at Candriam, stated: "At this critical moment, the path of least resistance for the pound is downward. On one hand, your expectations for a rate cut by the Bank of England are very limited, and concerns on the fiscal side are also unfavorable for the pound."

Deutsche Bank strategist Shreyas Gopal believes the outlook for the pound is not optimistic. He recommends reducing positions in the pound against a basket of other major currencies, including the euro, dollar, yen, and franc. He stated, "The recent weakness of the pound has room for further declines," and it is time to "turn bearish."