Dollar stays defensive as sterling faces a busy data week.
Market overview
FX markets begin the week with the dollar on the defensive after another run of softer US data encouraged investors to scale back expectations for further Federal Reserve tightening. July inflation eased, retail sales disappointed and short-dated Treasury yields moved lower, allowing sterling and the euro to extend their recent recoveries against the greenback. Markets now see only around a 30% probability of a September Fed rate increase, a sharp reversal from expectations at the end of July.
The picture is not entirely straightforward. Longer-dated US borrowing costs remain elevated as investors continue to demand greater compensation for inflation and fiscal risks, limiting the extent to which lower near-term rate expectations translate into broad dollar weakness. This week shifts the focus towards a heavy UK calendar, Wednesday's Federal Reserve minutes and Friday's global PMI releases, with relative interest-rate expectations likely to remain the main driver across the major currency pairs.
USD: Softer data leaves the dollar on the back foot
The dollar enters the week under pressure after July's US inflation figures reinforced signs that price pressures are gradually moderating. Headline CPI eased to 3.4% from 3.5%, while core inflation fell to 2.5% from 2.6%. That was followed on Friday by a 0.6% monthly decline in retail sales, substantially weaker than markets had expected and the largest fall in more than a year.
Taken alongside the softer employment report earlier this month, the data has significantly reduced the urgency for the Federal Reserve to tighten policy again. Short-term yields have fallen and the dollar has lost part of the rate advantage that supported it through June and July, leaving the currency vulnerable if incoming data continue to point towards slower growth and easing inflation.
Wednesday's minutes from the Fed's July meeting are the main US event this week. Rates were left unchanged at 3.50%-3.75% at that meeting, although three policymakers preferred a quarter-point increase. The minutes pre-date the latest softer jobs, inflation and retail data, so their value may lie less in signalling the Fed's next move and more in showing how widespread concerns over inflation remain within the committee. A more hawkish discussion than markets expect could offer the dollar some support, while evidence of a narrower appetite for further tightening would reinforce the recent decline.
GBP: Sterling faces three domestic tests
Sterling starts the week in a stronger technical position. GBP/USD is trading around the mid-1.35s after breaking above the 1.3500 area that repeatedly capped gains through the summer. Holding above that former resistance keeps the focus on the 1.3660 region, which marks the upper end of the broader range that has contained the pair for more than a year.
GBP/EUR has also recovered, trading around 1.17 after reversing much of its early-August decline. The cross remains above its rising 50-day moving average, with 1.1750 the next notable resistance area and July's 1.1810 high beyond it.
Unlike last week, when much of sterling's movement was driven by the dollar, the UK now has a busy domestic calendar capable of generating its own momentum. Tuesday's labour-market report is followed by inflation on Wednesday and the flash PMIs on Friday. Last week's stronger GDP figures — including 0.4% second-quarter growth — have already helped reinforce the view that the UK economy is proving more resilient than previously expected.
Inflation is the most important release. Consensus expects annual CPI to rise to 2.9% in July from 2.6%, largely reflecting the increase in household energy costs, while core inflation is expected to edge down to around 2.5%. A headline reading at or above 3% would increase the risk that the Bank of England tightens policy later this year and could provide fresh support for sterling. A softer result, particularly alongside weaker wage data on Tuesday, would reduce that rate advantage and leave the pound more reliant on continued dollar weakness.
EUR: Recovery runs into the 1.16 test
EUR/USD has extended its recovery towards 1.16 as softer US data and falling expectations for a September Fed increase narrow the policy gap between the US and euro area. The single currency has also received some fundamental support from the eurozone's return to a trade surplus, which reached €8.6 billion in June after a €9.0 billion deficit in May.
Technically, the 1.1600 area remains the immediate hurdle. EUR/USD is approaching its 200-day moving average around that level, and a sustained move above it would strengthen the case for an extension towards 1.1650 and potentially 1.17. Failure to break higher would leave the 1.15 area as the more important support zone.
The euro's domestic calendar is lighter than sterling's, leaving Friday's flash PMIs as the principal economic test. July's surveys showed a meaningful improvement in euro-area activity, with the composite PMI reaching 52.0 and manufacturing remaining above the 50 expansion threshold. Another solid reading would support the idea that the region is regaining momentum, although EUR/USD is still likely to remain highly sensitive to the direction of US yields and Fed expectations.
Looking ahead
UK labour market — Tuesday: Unemployment is expected to remain around 4.8%-4.9%, with wage growth around 3.4%. A firmer employment picture would increase the sensitivity of sterling to Wednesday's inflation release.
UK CPI — Wednesday: Headline inflation is forecast to rise to 2.9% year-on-year and around 0.4% month-on-month, while core CPI is expected near 2.5%. A 3% or stronger headline would increase pressure on the Bank of England to consider another rate increase.
Federal Reserve minutes — Wednesday: Markets currently price only around a 30% chance of a September rate increase. Attention will focus on how much support existed for further tightening at July's meeting and how concerned policymakers remained about inflation.
Eurozone PMIs — Friday: The composite index is expected to remain around 52.0, keeping activity in expansion territory. A significant deterioration would weaken the case for continued euro-area resilience and could limit EUR/USD upside.
UK and US PMIs — Friday: The UK composite PMI is forecast to ease to around 51.5 from 52.2, while US manufacturing and services PMIs are expected near 53.7 and 53.9 respectively. The relative strength of the releases could prove important for GBP/USD into the end of the week.