FX markets brace for inflation test as rates and energy risks rise
Market overview
FX markets are starting the week with a defensive tone as higher energy prices, rising global bond yields and uncertainty over the inflation outlook pull monetary policy expectations back into focus. Renewed concerns around shipping through the Strait of Hormuz have lifted Brent crude above $88 a barrel, adding another layer of inflation risk just as softer US labour data had encouraged markets to dial back expectations for further Federal Reserve tightening. The result is a more finely balanced backdrop across G10 currencies, with rate differentials, growth resilience and sensitivity to higher borrowing costs once again driving relative performance. With today’s calendar offering little direction, positioning is likely to remain cautious ahead of Wednesday’s US CPI release.
USD: Inflation risk keeps the dollar supported
The dollar has opened the week on firmer ground as higher oil prices and rising Treasury yields offset some of the weakness generated by last week’s softer payrolls report.
Markets had reduced expectations for another near-term Fed rate increase following signs of cooling employment growth, but that move is now being tested by renewed inflation concerns. The US 10-year Treasury yield has returned towards 4.7%, reflecting the risk that higher energy costs could slow the disinflation process.
The dollar therefore remains caught between softer labour market momentum and a US economy that continues to show greater resilience than many peers. For now, the combination of relatively firm growth, elevated yields and higher energy prices is providing enough support to prevent a more sustained dollar decline.
Wednesday’s CPI report is likely to set the next direction. A softer print could restart the recent dovish Fed repricing, while stronger inflation would strengthen the case for policy to remain tighter for longer.
GBP: Sterling holds firm despite softer UK data
Sterling has started the week relatively well, outperforming much of the G10 despite another mixed set of domestic figures. UK retail sales growth slowed to 1.0% year on year in July, below the 1.5% consensus and the weakest pace since February, reinforcing the view that the recovery in household spending remains uneven.
GBP/USD continues to hold above 1.35, while GBP/EUR has recovered towards 1.17 after finding support around 1.1650. That rebound suggests July’s correction has stabilised without materially weakening the broader technical picture, with the cross still more than 2% higher year to date.
Sterling’s resilience is particularly notable against a backdrop of elevated global yields. The UK remains relatively exposed to rising borrowing costs because investors typically demand a higher premium to hold gilts, meaning shifts in global rates can have an outsized effect on domestic financial conditions.
For now, the absence of fresh UK-specific negatives is helping the pound. Further ahead, fiscal policy remains an important risk, with the autumn Budget process likely to provide the next meaningful test of investor confidence in the UK outlook.
EUR: Recovery pauses below key resistance
EUR/USD has eased back following last week’s advance, with the 100-day moving average near 1.1570 once again limiting the upside. The pair remains above 1.15, but momentum has softened as investors wait for the next signal from US inflation data.
The euro continues to benefit from the narrowing in US-Eurozone rate differentials that followed weaker US employment figures. Better-than-expected Eurozone growth and inflation data have also kept alive expectations that the ECB may have scope to tighten policy again before year-end.
Even so, the recent move still appears to reflect dollar weakness more than a decisive improvement in the euro’s underlying outlook. The technical picture has improved, with the rising 21-day moving average pointing towards consolidation and recovery following the declines seen through May and June, but a sustained move above the 100-day average would be needed to strengthen the bullish case.
A softer US CPI print could open the door to another test of 1.16, while renewed Fed tightening expectations would leave EUR/USD vulnerable to a move back towards the centre of its recent range.
Looking ahead
US CPI: Wednesday’s inflation release is the key event for the dollar and broader G10 direction.
Global yields: Further increases in Treasury and European bond yields could keep rate-sensitive currencies volatile.
Energy prices: Oil remains an important inflation input, with developments around the Strait of Hormuz capable of shifting rate expectations quickly.
EUR/USD: A sustained break above 1.1570 would strengthen the recovery case and bring 1.16 back into focus.
GBP/USD: Holding above 1.35 keeps the near-term tone constructive, although US inflation remains the immediate catalyst.
GBP/EUR: The recovery towards 1.17 suggests support around 1.1650 remains technically important.