The recent UK inflation data presents a challenging scenario. Market expectations for an interest rate cut next month were low, but now the outlook for any cuts this year might diminish further.
Transport prices have considerably driven price increases due to rising airfares and hotel costs. This could be linked to the timing of school summer holidays, according to the ONS. Other data points reveal concerns with core annual services inflation rising to 5.0% in July from 4.7% in June.
Rising Food Price Inflation
Additionally, food price inflation escalated to 4.9% in July, up from 4.5% in June, marking the highest rise since February last year. These factors could influence the markets to lower expectations for rate reductions this year. The data suggests potential stagflation risks for the Bank of England as the year progresses.
With the latest UK inflation print coming in hot at 3.5%, well above the 2% target, we see the Bank of England’s hands as tied. The market is now rapidly pricing out any rate cuts for 2025, which makes selling December SONIA futures an attractive position. This stubbornness in prices reminds us of the challenges faced back in 2023, where inflation proved much harder to tame than initially forecast.
This outlook should provide a strong tailwind for the pound, especially against currencies with more dovish central banks. The European Central Bank, for instance, has already delivered two 25-basis-point cuts this year, creating a clear policy divergence. We are looking at long GBP/EUR positions or buying call options on sterling to capitalise on this growing interest rate differential.
Classic Stagflation Scenario
The combination of persistent inflation and high borrowing costs is a classic recipe for stagflation, which is typically negative for equities. This comes on the heels of last week’s preliminary Q2 GDP data, which showed a mere 0.1% expansion, highlighting the economic strain. Consequently, we are considering buying put options on the FTSE 250 index, as its domestically-focused companies are more vulnerable to a UK slowdown.
Uncertainty surrounding the Bank of England’s next move is likely to keep market volatility elevated in the coming weeks. The implied volatility on one-month GBP/USD options has already jumped to an eight-week high following the inflation report. This environment suggests that long volatility strategies, such as a simple straddle on the pound, could be profitable regardless of the currency’s ultimate direction.
