UK GDP: Some good news, for once

Phew, the UK economy has narrowly avoided negative growth for Q4, and instead expanded by 0.1% in the three months to December. The final month of the year did all of the heavy lifting. Monthly GDP ‘surged’ by 0.4% at the end of last year, driven by upside surprises across all sectors of the economy, including industrial and manufacturing production and the index of services rose by 0.4% in December, and 0.2% in 3 MoM. There was also good news for the trade deficit, which was also better than expected.

The details of the GDP report may not give Chancellor Rachel Reeves much comfort, however. The bulk of growth was driven by government spending, which rose by 0.8% last quarter. This is not sustainable when the government is trying to cut the deficit. Business investment collapsed last quarter, and was down 3.2% YoY, exports slumped by 2.5%, even though the pound was weak, and private consumption was flat. If Rachel Reeves wants to achieve growth, she needs to boost the private sector. However, her first budget impeded growth in the private sector, which leaves her with work to do in the Spring Statement to try and boost private consumption and investment, since the government cannot afford to keep propping up the UK economy. The details of today’s GDP report is surely a sign that the government needs to tread carefully as it tries to balance the books, and boost growth at the same time.

The GDP surprise has boosted the pound, and GBP/USD is back above $1.25, as a double whammy of good news, including the Ukraine/ Russia peace talks also give hope that energy costs could fall. We think that this is a solid platform for the pound to stage a deeper recovery, even if GBP/USD is sticky around $1.25 in the short term.

A weakening UK economy has been well flagged: the BOE slashed their growth forecasts last week, and this week the OBR downgraded their expectations for GDP ahead of the Chancellor’s spring statement next month. UK asset prices have taken most of this doom and gloom in their stride. As we have mentioned, both the FTSE 100 and the FTSE 250 are internationally focused indices, especially the FTSE 100, and we don’t think that stocks will be too impacted by domestic growth data from last quarter.

UK bond yields have fallen over the course of this year as the economic data has slowed in recent months, for example, the 2-year Gilt yield is lower by 17bps YTD, and we do not think that today’s better than expected GDP reading will be enough to cause yields to rise significantly from here. GDP may have surprised on the upside, but the reality is that the government’s pledge to boost growth remains a pipe dream at this stage.

The market is expecting a further 2 rate cuts from the BOE this year, with the next cut expected in May. Whether or not the market starts to price in a faster pace of rate cuts will depend on the upcoming labour market and inflation data in the UK, not backward-looking GDP. If the UK’s labour market starts to weaken and if there are other signs of a slowdown in consumption, then the market is likely to call the BOE’s bluff about its gradual stance when it comes to rate cuts.

Broad based CPI gains could keep the Fed on pause permanently

The situation in the US could not be more different from the UK right now. The key takeaway from the January US CPI report was that the rise in prices was broad based. Shelter costs were the single biggest increase in the inflation index, however, there were also gains for airfares, car insurance, medical care and used cars, along with energy and food. Part of the increase in core price growth is the usual start of the year price increases, for example for medical and car insurance. Thus, we could see the MoM figure pullback from the 0.5% rate in February.  The other main takeaway is that the US has an inflation problem, and a 3% handle for headline CPI feels like a line in the sand. Either the Fed needs to covertly live with inflation above target for the long term, or their next move should be a rate hike, since they profess to be data dependent. The market is currently expecting one rate cut this year, and there is a 40% chance of a single rate cut by December, according to the CME’s Fedwatch tool.

There has been much discussion about the US’s neutral interest rate. Today’s CPI suggests that we could be at, or close to, the neutral rate. The current target rate is 4.25-4.5%. This is a significant shift from the 2010s, when the interest rate or cost of money was extremely low. The cost of money has risen sharply and may stay at this elevated rate for some time.

Will US bond yields recover on Thursday?

Financial markets mostly faded the knee jerk moves in the aftermath of the hotter than expected US CPI report for January. Equities staged a recovery late on Wednesday, after news that President Trump was trying to broker a peace deal between Russia and Ukraine, see more below. Although stocks initially fell after the CPI report, bargain hunters came out late in the day and the Nasdaq 100 closed higher. Tesla and Meta both rose, and Cisco also rose after posting an upbeat forecast for future sales. The initial spike higher in the dollar was also faded, and the dollar index closed higher by a notch. GBP/USD has recovered further on Thursday, and EUR/USD is also higher and above $1.04.

Unsurprisingly, the bond market has felt the biggest impacted from the CPI report, and the 2-year yield was higher by 7 bps on Wednesday, while the 10-year yield was higher by 8bps.  The Treasury market underperformed the other major sovereign bond markets, as the CPI report makes it likely that the Fed’s rate cutting cycle is on a permanent pause. However, if the increase in CPI was seasonal, then we could see some of the move higher in US bond yields erased on Thursday. The Fed chair Jerome Powell also reiterated on Wednesday that the Fed will not react to a single month’s worth of data, during his semiannual testimony to Congress. This may also calm fears about the CPI report.

Trump’s peace plan for Ukraine and Russia weighs on the oil price

The news that President Trump would meet Russian President Putin in Saudi Arabia to agree an end to the war in Ukraine calmed markets late on Wednesday after the CPI shock. There is some concern that the US rather than Ukraine is leading the negotiations, and the US defense secretary said that Ukraine won’t get back all of the territory that Russia has captured, and he also reiterated that the US does not agree to NATO membership for Ukraine.

It is very early days in this ‘peace’ negotiation, and it is unclear how peace could unfold and how it may impact financial markets. Undoubtedly an end to the war is good news for energy supply chains, particularly to Europe. If Russian oil and gas can flow freely back to Europe, this is positive for economic growth, especially for Germany, but also for the rest of the EU and the UK. The oil price dropped sharply on the news, Brent was lower by 2.6%, and WTI fell by 2.66%. This could ease inflation concerns across Europe and allow the ECB and the BOE to cut rates at a faster pace down the line. The gold price is lower this week, and today’s hotter CPI print did not add too much upward pressure to the yellow metal. The prospect of an end to the Ukraine war with Russia could reduce demand for gold as a haven, which may hinder gold’s progress towards $3,000 per ounce in the short term.

Trump’s peace plan for Ukraine could come with a hefty price tag for the EU

A peace deal negotiated by the US could also have ramifications for Europe. The US is not expected to protect Ukraine with troops or military aid after Russia’s withdrawal, instead Europe will need to take on this responsibility. Rebuilding Ukraine, boosting its domestic defenses and creating a European military deterrent to stop Russia from encroaching further west in the coming years could cost the best part of $3.7 trillion.  This would include pushing the EU’s defense budgets to more than 3.5% of GDP, something that most of Europe has not achieved in many years. For example, the UK’s defense budget is 2.3% of GDP, Spain’s is 1.2% of GDP, Germany’s is 2.1% of GDP and France’s is 2% of GDP. Thus, peace in Ukraine is likely to come with a chunky price tag for Europe, at the same time as EU nations like France and the UK grapple with reducing the size of their budget deficits. Trump’s plan could be a double-edged sword for Europe: in the short term it is positive for the economy, but in the long term it could have a revolutionary effect on EU spending priorities. However, the FX market is in jubilant mood on the back of this news, EUR/USD is currently above the 50-day sma at 1.0390, a key resistance level, and is extending gains above $1.0430 on Thursday.  

In the short term, we think that the euro and the pound may continue to recover on the back of this news, at least in the short term. An end to the war in Ukraine could boost Europe’s growth outlook if it can secure cheap energy from Russia once more. However, another important driver of European assets in the short term is that if Trump is now busy forging peace between Putin and Zelensky, he might delay imposing tariffs on the EU.