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The Pound to Dollar exchange rate (GBPUSD) fell back below the 1.30 level following the release of softer-than-forecast inflation data that lowered the odds of a 50 basis point interest rate hike at the Bank of England in August.

Falling rate hike expectations were reflected in a fall in UK two-year bonds - indeed across all bond durations - which will bring mortgage and broader lending rates lower while easing the squeeze on households and businesses.

The UK economic outlook is therefore greatly improved in light of the turn in inflation and bank hike expectations, but currency analysts say the Pound is closely tracking developments in UK bond markets at present, explaining the currency's decline following the news.

"The year’s strongest major currency was one of the weakest Wednesday after cooler UK inflation dampened prospects for a big rate hike next month. The UK pound tumbled 1% to below 1.30 after British inflation moderated," says Joe Manimbo, Senior FX Analyst at Convera.

The Pound to Dollar exchange rate flew to a 14-month high at 1.31 just last week but this left it looking overbought on a technical basis amidst bullish investor positioning.

Pound Sterling was therefore ripe for a corrective move lower and the undershoot in inflation has pulled the trigger for that correction.

At the time of writing GBPUSD is quoted at 1.2934; "this is a blow for hawks advocating another 50-basis point Bank of England hike in August, which had helped GBP/USD climb to 16-month highs earlier this month," says Boris Kovacevic, FX and Macro Strategist at Convera.

Above: GBPUSD (top) tracks the movement in two-year UK nominal bonds (bottom).

"After months of negative UK inflation surprises, the larger-than-expected slowdown in the rate of inflation in June comes as a relief," says Kallum Pickering, Senior Economist at Berenberg Bank.

UK CPI inflation read at 7.9% year-on-year, down from 8.7% previously, while the all-important core CPI read at 6.9%, down from 7.1%.

CPI was forecast to have risen 8.2% y/y with core inflation expected to have remained at 7.1%.

CPI inflation rose just 0.1% month-on-month in June, which was far less than the 0.4% the market was looking for and sharply down on May's 0.7% increase. Core rose 0.2% m/m in June, half the 0.4% expected and down sharply on the 0.8% reported the month prior.

The undershoot prompted markets to lower expectations for future Bank of England interest rate hikes, which in turn weighed on UK bond yields and the Pound. The probability of a 50 basis point hike on August 3 is now down to 41% vs 58% at Tuesday's close.

Pickering says "UK fundamentals are now decidedly disinflationary. Monetary policy is turning ever tighter (that is, almost by definition, disinflationary), consumer inflation expectations are falling, producer prices are normalising, unemployment is rising and vacancies are down sharply."

If these trends all continue, Berenberg reckons inflation should fall fast over the coming months towards a 4-5% rate by the end of the year and to within the 2-3% range by the middle of next year.

"While elevated wage growth presents an upside risk to this call, the weight of evidence suggests wages are lagging inflation rather than leading it – and hence should moderate, with a lag, once inflation falls further and real wage growth turns positive," he adds.

How this plays out for the Pound is difficult to ascertain: on the one hand, the fall in UK bond yields in response to the data is clearly weighing.

However, economists were keen to point out that the UK's 'inflation problem' created the prospect of an economic downturn ahead, which in turn would have also weighed on the Pound's prospects.

Therefore, while the near-term could see further weakness, the longer-term outlook has brightened.

For GBPUSD, much also depends on developments in the U.S. where the inflation has also slowed, bringing an end to the Fed's rate hiking cycle into view.

Should the Federal Reserve pause hikes and global growth picks up (watch next week's Fed decision for guidance), the Dollar can extend lower over the coming months offering GBPUSD a more sustainable shot at moving comfortably above 1.30.

"The extended weakness in the US dollar expected over the second half of the year means we cannot rule out fresh 2023 highs over the coming months," says Kovacevic.