The Impact of Inflation on the UK Economy

The pound weakened and U.K. government bond yields dropped on Wednesday, while the London stock market experienced a surge, all due to increased speculation that the Bank of England (BOE) will implement more significant interest rate cuts in 2024. This speculation follows the release of data showing that inflation in the country has reached its lowest level in over two years.

According to the Office for National Statistics, the consumer prices index (CPI) recorded a 3.9% increase in the year leading up to November. This figure is significantly lower than the previous month's 4.6% and falls below economists' expectations of 4.3%.

Moreover, the month-on-month CPI actually decreased by 0.2% as opposed to the anticipated 0.2% rise that was predicted based on October's unchanged level.

It is noteworthy that annual headline inflation in the U.K. has dropped from a peak of 11.1% in October 2022 to its lowest level since September 2021, although it remains almost twice the BOE's 2% target. Nonetheless, this decline in inflation has fueled expectations among traders that the BOE will take aggressive measures to reduce borrowing costs, thereby supporting the sluggish economy.

Recent market indicators suggest that there will be a total of 138 basis points worth of rate cuts in 2024, equivalent to around five 25 basis point cuts. This figure has increased from the previous prediction of 117 basis points before the latest inflation data was released, according to Reuters.

Economists at Goldman Sachs, led by Sven Jari Stehn, have also highlighted how services, core, and headline inflation have all come in lower than expected, significantly deviating from both consensus and BOE projections.

"In addition to the notable slowdown in wage growth observed last week, recent data on key indicators of inflation persistence have caught the BOE off guard. As a result, we are revising our forecast and now predict the first BOE rate cut to occur in May instead of June," said the Goldman Sachs team in a note.

The Impact of Monetary Policy on U.K. Government Bonds

The recent shift in monetary policy trajectory has sparked a surge in the demand for U.K. government bonds. As a result, the 2-year gilt yield (BX:TMBMKGB-02Y) has dropped by 15 basis points to 4.134%, reaching its lowest level since May. This decline in yield has been mirrored in European benchmark rates, with the 2-year German bond yield (BX:TMBMKDE-02Y) falling by 6.6 basis points to 2.456%, marking its lowest point since March.

Pound Falls, Stocks Rise

Conversely, the British pound (GBPUSD, -0.59%) has experienced a decline of 0.6%, dropping to $1.2650. Nevertheless, this decline in the pound has resulted in a positive reaction from the stock market, as investors anticipate lower borrowing costs. The FTSE 100 UK:UKX index has risen by 0.6%, fuelling optimism in interest rate sensitive sectors such as homebuilders, real estate, and utilities.

Anticipated Rate Cuts

The unexpected and significantly lower inflation figures have sparked a wave of optimism within the U.K. stock market. Many investors now believe that the Bank of England will have no option but to implement rate cuts in the near future. Commenting on this, Russ Mould, investment director at AJ Bell, states: "Considerably lower than expected inflation figures have put a rocket under the U.K. stock market as investors take the view the Bank of England will have no choice but to cut rates soon."

Dovish Messaging Influence

The dovish messaging regarding Fed rate prospects by Jay Powell has set off a Christmas party-like atmosphere in the U.K. markets. Sandra Horsfield, an economist at Investec, comments: “The Christmas party in markets that Jay Powell’s dovish messaging on Fed rate prospects kicked off is in full swing in the U.K. today.”

Mixed Results in Europe

However, the overall sentiment across the rest of Europe is not as jubilant. The DAX DX:DAX in Germany has experienced a slight decline of 0.1%, whereas the CAC 40 FR:PX1 in France has seen a modest increase of 0.1%.

Argenx Faces Challenges

Among the notable poor performers in the market is Argenx (ARGX, -24.50%), a Dutch biotech group listed in Belgium. Their shares took a significant plunge of a third at one point after reporting that a late-stage trial failed to meet primary or secondary endpoints.