European risks drive early-week FX divergence

Market overview

FX markets are starting the week with a clearer split across the majors. The euro remains under pressure as French political and fiscal concerns spill into bond markets, sterling is holding firm on increasingly hawkish Bank of England expectations, while the dollar continues to attract support from higher yields and a relatively resilient US backdrop. Risk appetite remains healthy enough to keep some higher-beta currencies supported, but the bigger story is the widening divergence in rate expectations across the US, UK and euro area.

That divergence is creating more two-way opportunity across G10 FX. The Fed remains in wait-and-see mode, the market is testing how much further it can price UK tightening, and ECB expectations are being scaled back as French risks build. With the US data calendar relatively quiet, Europe is likely to remain at the centre of price action, leaving EUR crosses particularly sensitive to any further move in bond spreads or political headlines.

USD: Yields keep the greenback underpinned

The dollar continues to find buyers, helped by higher global yields and US data that remain consistent with a relatively firm economic backdrop.

The ISM services index eased slightly to 54.9 from 55.4, but the detail was arguably more supportive than the headline suggested. Employment strengthened, backlogs increased and prices paid pushed higher, offsetting softer business activity and new orders.

The release was not strong enough to materially change the Fed outlook, but it does little to encourage expectations of a rapid policy reversal. An October hold remains the most likely outcome, particularly if September core CPI prints around 0.2% month-on-month, while December continues to look like the more realistic window for another rate increase.

Today's US calendar is lighter, leaving Fed speakers Williams, Musalem, Bowman and Schmid in focus. That said, DXY may take more direction from developments in Europe than from domestic data over the next few sessions.

GBP: Sterling keeps the upper hand

Sterling continues to benefit from increasingly hawkish Bank of England pricing, particularly against a euro struggling with its own domestic risks.

Attention now turns to a busy run of MPC speakers. Catherine Mann speaks today after backing rate increases at both the July and September meetings, while Megan Greene and Huw Pill are due on Thursday. Andrew Bailey and Clare Lombardelli also speak that day, making the session particularly important ahead of November's decision.

Markets currently price around 21bp of tightening next month, 36bp by year-end and 89bp by June. The risk is that expectations are beginning to run ahead of what the Bank ultimately delivers, but for now the direction of travel continues to favour sterling.

GBP/EUR has already pushed towards 1.1820, helped by widening French spreads, although the move is beginning to look technically stretched. RSI above 70 and a sizeable deviation from the 21-day moving average suggest some consolidation would be healthy. A move back into the mid-to-upper 1.17s would therefore not undermine the broader constructive sterling picture.

The UK Budget later this month remains the key domestic risk, with markets watching closely for signs that additional spending plans are matched by credible fiscal restraint.

EUR: French concerns keep sellers in control

The euro remains the weakest link across the major currencies as investors continue to respond to rising political and fiscal uncertainty in France.

The pressure is coming from both a higher French risk premium and a meaningful reduction in ECB tightening expectations. Pricing for the March meeting has fallen from around 80bp on 24 September to roughly 45bp, pushing the EUR/USD two-year swap differential towards -167bp.

That leaves the euro with substantially less rate support. EUR/USD managed to recover above 1.120 after briefly falling towards 1.1160, but conviction behind the bounce remains limited.

French bond stress is still far from extreme, which arguably leaves more room for the risk premium to widen if confidence deteriorates further. A move towards 1.110 in EUR/USD remains realistic, while 1.100 could come into view if political tensions intensify.

Markets are now waiting for further detail on Marine Le Pen's proposed counter-budget, which could prove another important catalyst for French assets and the wider euro complex.

Looking ahead

• France: Bond spreads and political headlines remain the clearest near-term risk for the euro.

• UK: Catherine Mann speaks today, followed by Greene, Pill, Bailey and Lombardelli on Thursday.

• US: Fed speakers dominate today's lighter calendar, with FOMC minutes due tomorrow.

• EUR/USD: 1.110 remains the first meaningful downside level, with 1.100 in focus if French stress escalates.

• GBP/EUR: Near-term consolidation looks possible, but the wider backdrop remains supportive for sterling.

• Rates: Diverging Fed, BoE and ECB expectations remain the key driver across G10 FX.