Pound to Euro Rate Falls Victim to U.S.-inspired Drop in UK Bond Yields

The British Pound was the second worst-performing major currency on the day U.S. inflation was reported to have fallen by a larger-than-expected amount.

Signs of rapidly cooling U.S. inflation prompted a sharp fall in U.S. bond yields as investors bet the Federal Reserve could now confidently consider ending its rate hiking cycle.

This development was also reflected in broad-based losses for the U.S. Dollar, ensuring the Pound-Dollar exchange rate rose to its highest levels since April 2022 at 1.30.

But inflation expectations around the world also fell and investors bet other central banks could now soon consider quitting their own hiking cycles, prompting lower yields more broadly, including in the UK where expectations are particularly high.

Indeed, the rapid rise in Bank of England rate hike expectations over recent months meant UK yields and the Pound had outperformed peers elsewhere, leaving them particularly rich and prone to a sizeable give-back.

A key driver of the Pound to Euro exchange rate is the differential in the two-year bond yield between the UK and Germany, which dropped sharply in the wake of the U.S. inflation release:

As the above chart shows, the Pound-Euro exchange rate (lower panel) responded to the fall in yield differentials.

The Pound is 2023’s best-performing major currency as a result of elevated Bank Rate expectations and rising yields, could recent developments in the U.S. therefore spell an end of the rally?

For sure, a fall in UK yields reflects expectations that the eventual peak in the Bank of England’s Bank Rate will be lower than the market had previously expected (in excess of 6.0%), in turn weighing on UK bond yields.

But it is still too soon to tell if the Pound’s rally against the Euro is at an end and much will depend on next week’s UK inflation data release which would need to undershoot market expectations to truly let the air out of UK rate expectations.

For now, the UK’s bond yield advantage against the Eurozone remains sizeable which hints the Pound-Euro exchange rate can stay elevated on a multi-week basis, although a break of recent highs near 1.1750 might be harder to achieve in the near term.