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The pound weakened and UK stocks rallied after British inflation slowed unexpectedly, catching traders off guard as they prepare for the Federal Reserve’s policy decision later. Sterling fell as much as 0.5% against the dollar to its lowest level since May as traders bet that the Bank of England is nearing the end of its hiking cycle, with only more rate increase now fully priced. UK bonds soared, with the yield on two-year gilts dropping 12 basis points to 4.88%, the lowest since Aug. 10.
The UK’s FTSE 250 index of domestic stocks jumped 1.5% after the inflation boost, with homebuilders sensitive to changes in interest rates leading the gains. Europe’s Stoxx 600 index also benefited from the improved sentiment, climbing for the first time in three days. US equity futures were steady, while a gauge of Asian stocks retreated.
Britain’s Consumer Prices Index rose 6.7% from a year earlier in August, the slowest pace in 18 months, and less than the 7% expected by economists. The chance of a quarter-point rate increase by the BOE at its meeting fell, with the market assigning a less than 60% probability from 90% earlier, according to swap pricing.
“BOE policy makers must be very happy with the data, but it doesn’t change anything: they will raise rates, but it will probably be a dovish hike, similar to what the European Central Bank did last week,” said Francois Rimeu, a strategist at La Francaise Asset Management in Paris.
US Treasuries were steady after yields on both the five- and 10-year notes hit the highest levels since 2007. The yen trimmed a rebound from its near 10-month low as US Treasury Secretary Janet Yellen said any intervention by Japan to support its currency would be understandable if it were aimed to smooth out volatility.
The focus will soon turn to the Fed, with Chair Jerome Powell and his colleagues widely expected to hold rates on Wednesday. Still, supply shocks such as climbing oil prices present the central bank with a quandary as they simultaneously boost inflation and curb economic growth. Surging energy costs played a role in tipping the US into recession in the mid-1970s, as well as the early 1980s and 1990s.
Aside from expectations of a hawkish hold, investors will focus on the Fed’s updated quarterly rate projections — known as the dot plot — that will be released at the conclusion of the policy meeting. High on the watchlist will be whether these forecasts continue to reveal a median view for one more quarter-point hike this year and whether forecasts for 2024 scale back the 100 basis points of rate reductions that officials foresaw in June.