European bond yields rose, IBEX 35 gained over 2%, and Brent crude surged over 3% amid Middle East tensions and U.S. rate cuts.

European bond yields climbed last week, with the yield spread between French and German 10-year bonds widening by 6 bp. Equity markets showed mixed performance, though the IBEX 35 outperformed, gaining over 2%. UK indices declined following the Bank of England’s decision to hold interest rates. The euro remained strong against the US dollar, trading at 1.1164. In the commodities market, Brent crude prices surged more than 3%, driven by rising tensions in the Middle East, potential conflict between Israel and Lebanon, and the US rate cut to a range of 4.75%-5%.

Eurozone inflation fell to 2.2%, prompting the ECB to cut rates last week. In the UK, inflation remains steady at 2.2%, and the Bank of England held rates steady.

Eurozone inflation decreased to 2.2%, its lowest level since July 2021, largely due to a 3% drop in energy prices. This easing in inflation, coupled with softer economic conditions, allowed the ECB to implement another interest rate cut. Although core inflation edged down to 2.8%, services continued to be a significant contributor to inflation, with a 4.1% YoY increase. Consumer sentiment in both the Eurozone and Germany declined sharply, as reflected by the ZEW Economic Sentiment Index, signalling growing economic pessimism. Concurrently, the Bank of England is expected to accelerate its rate cuts starting in November, targeting a reduction to 3.25% by mid-2025. Despite the UK's headline CPI holding steady at 2.2%, anticipated increases in energy prices may push inflation up to 3% later in the year.

Eurozone inflation dropped to 2.2%, with energy prices declining. This allowed the ECB to reduce interest rates, responding to softer economic conditions.

The annual inflation rate in the euro area declined by 0.4 percentage points from July, reaching 2.2%, the lowest level since July 2021. Core inflation, which excludes volatile components such as energy, food, and tobacco, edged down to 2.8%, signalling persistent underlying inflationary pressures. Services remained the largest contributor to inflation, with prices rising 4.1% YoY, while energy prices dropped by 3%, reducing the overall inflation rate by 0.29 percentage points. This inflationary easing, alongside ongoing economic weakness, assured the ECB to implement an interest rate cut at its most recent monetary policy meeting.

We expect a clear downward trajectory in inflation, though the final phase of reduction remains the most challenging. No unexpected developments are foreseen. Given current data, the ECB is likely to hold rates steady in October, with a potential rate cut in November.

In September, Germany's ZEW Economic Sentiment Index dropped to 3.6, its lowest since October 2023, while the Eurozone index fell to 9.3. The current conditions index also worsened to -84.5, the weakest since May 2020, reflecting declining expectations across most industries.

The ZEW Economic Sentiment Index for Germany dropped to 3.6 in September, its lowest level since October 2023, down from 19.2 in August. This decline also affected the Eurozone, with its sentiment index falling from 17.9 to 9.3, marking its lowest point in nearly a year. This downturn signifies a third consecutive month of diminishing economic sentiment, erasing the optimism that has prevailed since November 2023. The sub-index for current conditions fell sharply to -84.5, from -77.3 in August, marking the weakest reading since May 2020. Expectations for the next six months have deteriorated across most industries, with the most notable declines in mechanical engineering, steel, automotive, and banking, while construction, utilities, and telecommunications sectors displayed a more optimistic outlook.

We anticipate limited improvement in consumer sentiment for the remainder of the year, given the ongoing economic weakness, especially within the manufacturing sector, which continues to constrain Eurozone growth.

The Bank of England adopts a cautious approach, maintaining rates at 5%. GBP/USD strengthens due to contrasting BoE and Fed policies.

The BoE remains more cautious than the Fed, but a significant divergence in their policies is unlikely to last. Although the BoE started cutting rates earlier, its recent decision to hold rates at 5.00% signals a measured approach to easing, with markets expecting fewer cuts compared to the US. Concerns over persistent services inflation, currently at 5.6%, and strong wage growth have kept the BoE’s stance hawkish, though these pressures are expected to ease as the labour market continues to cool. The BoE will also continue its quantitative tightening program, which is expected to have minimal impact on markets, focusing instead on rate adjustments as its primary policy tool. By mid-2025, rates are forecasted to decline to 3.25%, reflecting a more confident outlook on inflation management.

GBP/USD experienced strong bullish momentum, driven by the Federal Reserve’s significant rate cut on September 18 and the Bank of England’s decision to pause. The Fed's substantial reduction weakened the dollar against key currencies, while the BoE’s decision to maintain rates after an earlier cut provided support for the pound.

Starting in November, we expect the BoE will quicken the pace of rate cuts, likely moving to consecutive 25 bp reductions, aligning more closely with the Fed's easing cycle.

CPI remains at 2.2% but may rise to 3% due to energy price increases. Services inflation is easing, and the Bank of England is expected to cut rates further.

The headline CPI remains unchanged from the previous month at 2.2%. However, it is anticipated to approach 3% later this year due to a projected 10% increase in the price cap for household electricity and gas announced by the energy regulator for October. Recent increases in UK services inflation are primarily attributable to base effects and accelerated price growth in categories less influential to the Bank of England’s monetary policy. Despite an uptick in services inflation from 5.2% to 5.6% in August, core services inflation—which excludes volatile components such as airfares, package holidays, and rents—has declined from 5.5% to 4.9% over the past two months. Given the current deceleration in wage and price growth and the cooling labour market, the BoE is likely to adopt a more aggressive rate-cutting stance over the winter.

Given this context, we foresee the Bank implementing a rate cut in November, followed by an additional reduction in December.