European stock markets experienced a notable rally on Wednesday, buoyed by cooling inflation figures from both the United States and the United Kingdom. The Euro Stoxx 600 Index marked its largest one-day gain in nearly five months, rising 1.33%, snapping a three-day losing streak. Despite the positive sentiment in the stock markets, concerns over the weak euro and pound sterling persist due to ongoing economic and political uncertainties.

Broad Market Rally Driven by Inflation Data

A “risk-on” sentiment gripped global markets as inflation data from both sides of the Atlantic showed signs of easing, reinforcing expectations of continued interest rate cuts by central banks. Germany’s DAX rose by 1.5%, reaching a new record high and outperforming global indices. The index has gained 3.34% year-to-date, largely driven by expectations that the European Central Bank (ECB) could implement more aggressive rate cuts compared to other major central banks, despite ongoing domestic challenges.

The UK’s FTSE 100 advanced 1.21%, recovering from recent turmoil in British bond markets, while France’s CAC 40 increased by 0.69%, lagging behind its peers. However, the euro weakened against the US dollar and the pound, with the euro-dollar pair slipping to 1.0288 early Thursday. The common currency also retreated after hitting a five-month high against the pound last week.

US and UK Inflation Data Show Cooling Trend

Inflation figures from both the US and the UK showed signs of cooling, providing relief to investors. In the US, core inflation for December fell to 3.2% year-on-year, slightly down from 3.3% in November. Headline inflation, however, remained elevated. This followed cooler-than-expected producer price index (PPI) data on Tuesday, heightening expectations for continued Federal Reserve rate cuts in 2025.

Inflation data from the Eurozone will be released on Friday, with the final December figures expected to confirm that core inflation remained steady at 2.7%. This could further strengthen market expectations for a 25 basis point rate cut by the European Central Bank (ECB) in January. Despite a recent euro rebound, the contrast in monetary policy between the Fed and ECB could keep pressure on the euro.

In the UK, December’s headline inflation dropped to 2.5%, while core inflation stood at 3.2%, offering a slight reprieve after three months of higher inflation. This decline fueled expectations that the Bank of England will continue its rate-cutting cycle. While this eased pressure on UK markets, concerns over the UK’s fiscal outlook and political uncertainties remain, keeping the risk premium on UK assets elevated.

Outlook and Implications for Currency and Central Bank Policy

Despite the positive inflation data, the outlook for the euro and pound remains cautious. The divergence in central bank policies between the Fed and the ECB, along with ongoing economic challenges in the UK, suggests that the weakness in both currencies could persist. Investors will closely monitor upcoming inflation data and central bank guidance to gauge the potential for further market volatility and shifts in currency dynamics.