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How record high US inflation can hit UK markets, the pound, and 'Trussonomics'

US Federal Reserve Board Chairman Jerome Powell. US inflation was more than expected in September
A surge in core inflation prices means a move higher in the US dollar, as well as yields, which means a weaker pound compared to the US greenback. Photo: Kevin Lamarque/Reuters (Kevin Lamarque / reuters)

US inflation eased back slightly in September as expected, however, it came in higher than forecast.

The consumer price index (CPI) stood at 8.2% last month, down from 8.3% in August, but above the 8.1% consensus, warranting a continued aggressive tightening stance from the Federal Reserve.

Meanwhile core CPI, which strips out volatile food and energy components, jumped to 6.6% over the period, from 6.3%. This was also more than forecast, and the highest since 1982.

Core CPI is a key indicator of how price rises have become embedded across the economy, but how does US inflation affect the pound and UK markets?

The pound

A surge in core prices means a move higher in the US dollar, as well as yields, which means a weaker pound compared to the US greenback.

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The dollar has already risen by more than 15% against some of the world's most traded currencies this year, meaning more expensive imports of commodities like energy and food, which often trade in the currency.

“There aren’t likely to be many chinks in the dollar armour any time soon, with the strength of the greenback continuing to cause continued inflationary pressures in other economies, as imports priced in dollars, remain more expensive,” Susannah Streeter, senior investment and market analyst, Hargreaves Lansdown, said.

“That means there is little relief for the pound coming from across the pond. Sterling has slipped back, hovering around $1.10 as political and fiscal pressures also continue to weigh it down.”

Bond yields will also be under pressure as US inflation rises. UK government bonds rose in price on Thursday, while German 10-year bond yields, which serve as the benchmark for the rest of the eurozone, came under pressure on the back of the latest data.

Read more: Pound rallies on reports of more mini-budget U-turns

Simon Harvey, head of FX analysis at Monex Europe, said: “What does today’s CPI release mean for FX markets? The answer is simple. In short, it is too early to call the top in the year-to-date dollar rally, despite the obvious appetite within markets to position for the slowdown in the tightening cycle.”

“With higher rates, lower equities, and fragile risk sentiment set to remain over the next two months at least, we continue to stand by our bullish USD forecasts. That is, until Q1 next year, where we expect to see the rollover in US data to start testing the Fed’s resolve in keeping policy this restrictive heading into Q2.”

Stock markets

Higher interest rates also represent a headwind for equity markets. On the back of the high inflation report, global stocks have already nosedived.

Wall Street was deep in the red on the day, which will continue to feed into trading in Asia when it opens, and across Europe, and the UK.

The Nasdaq (^IXIC) tumbled 3% after opening to its lowest level since July 2002, and US Treasury yields surged, with the 30-year rate briefly hitting 4%, the highest since 2011.

Rob Clarry, investment strategist at UK wealth manager Evelyn Partners, said: "Markets reacted significantly to the upside surprise, with the dollar strengthening to its highest level since September on a trade-weighted basis.

Read more: What will the Bank of England's emergency action actually do?

"Given that interest rate hikes act with a 12-18 month lag, we expect the US economy to face a challenging 2023. Investors should therefore adjust their portfolios to account for this.

"In the equity space, we favour increasing the share of defensive names in portfolios. We also see value in the role fixed income can play as a form of disaster insurance –- and favour US treasuries over UK gilts given recent volatility in policy."

Meanwhile, Seth Carpenter, Morgan Stanley global chief economist, said: “If ever there is a time for people who to do economic forecasting to be humble, this is it. It’s very, very difficult — the falling off of inflation for core good has taken so much longer than we expected."

Watch: Stocks decline on inflationary fears, CPI print

Interest rates

The higher-than-expected inflation means that US interest rates now are set to go higher as the Fed looks to tame soaring prices and the rising cost of living. The Bank of England is set to also follow suit.

Richard Flynn, managing director of Charles Schwab UK, said the Federal Reserve is guaranteed to take aggressive action next month.

"The pace of inflation remains stubbornly high, in defiance of the Fed’s attempts to tamp down the economy by tightening monetary policy," he said.

"Rising prices, combined with last month’s stronger than expected jobs report, all but guarantee the Fed will enact its fourth 0.75% rate hike when officials next meet in November."

Read more: Interest rates: Bank of England chief economist hints at 'significant' November rise

The US central bank has already made three successive 75bps rate hikes, but higher core prices suggest that inflation is likely to last longer. This adds to the risk that the Fed will not only be more aggressive on rates, but also keep them higher for longer too.

'Trussonomics'

The combination of a weaker pound, soaring inflation, higher interest rates, an incoming recession are all set to potentially derail Liz Truss' plans for UK economic growth.

The British government is already worried that persistent high US interest rates could cancel out the benefits of the prime minister's deregulation scheme and tax cuts.

A UK official told Bloomberg last week that the concern is that the Bank of England (BoE) will follow suit in hiking raises for longer, and higher borrowing costs for business and consumers will undermine Liz Truss’s fiscal policies.

Robert Peston, ITV's political editor, tweeted that it is all banking on whether or not the dollar has reached its peak.

Higher interest rates also mean low business confidence, weak consumer spending, and less companies and banks investing within the economy, causing it to contract.

Financial markets are pricing the BoE’s key rate peaking at around 5.5% next year, up from 2.25% currently. This is higher than market projections for the Fed, which is seen peaking below 5%.

Read more: Bank of England warns UK households may face 2008 financial crisis mortgage strain

Wider economy

Other geopolitical developments could also keep inflation in the US elevated.

This includes the Organisation of the Petroleum Exporting Countries and its allies (OPEC+) recently announcing oil production cuts, while a potential gasoline export ban from the Biden administration could backfire with higher pump prices.

This again feeds into the UK market and the pound as crude oil (BZ=F) is traded in US dollars.

In addition to this, Moscow’s invasion of Ukraine continues to disrupt supply chains of commodities such as wheat, while the US is considering a ban on Russian aluminium in response to the country’s military escalation.

Watch: How does inflation affect interest rates?