FX markets look through geopolitical tension as rate expectations take control
Market overview
FX markets remain relatively calm despite another sharp rise in oil prices, with investors continuing to focus more heavily on interest-rate expectations and incoming economic data than geopolitical headlines. Brent crude has climbed back above $91 a barrel as prospects for a resolution to the US-Iran conflict deteriorate, but the reaction across major currencies has so far been contained.
The dollar has recovered slightly this morning after falling to a ten-week low on Monday, although the broader August trend remains one of softer US rate expectations following weaker employment, inflation and retail sales data. Sterling has been little changed following this morning’s mixed UK labour report, while the euro remains close to an important technical area around 1.1570 against the dollar. Attention now turns to tomorrow’s UK inflation figures and Federal Reserve minutes before a broad set of global PMI releases on Friday.
USD: Dollar steadies but softer data remains a headwind
The dollar has edged higher in early trade as renewed tensions in the Middle East and rising oil prices provide some safe-haven support. The DXY dollar index fell as low as 99.29 on Monday before recovering towards 99.7 this morning, but remains under pressure after a run of US economic releases reduced expectations for further Federal Reserve tightening.
Last week’s inflation figures strengthened that argument. Headline US CPI rose just 0.1% in July, with the annual rate easing to 3.4% from 3.5%. Core inflation also slowed to 2.5% from 2.6%, while softer retail sales and earlier weakness in the labour market have added to evidence that economic momentum is cooling.
That has pulled shorter-dated Treasury yields lower and reduced the rate advantage that helped support the dollar earlier in the summer. Geopolitics remains an upside risk — particularly if higher energy prices begin feeding back into inflation expectations — but currency markets have so far shown a greater sensitivity to interest-rate differentials than developments in the Middle East.
Today brings July housing starts and industrial production, but Wednesday’s Federal Reserve minutes are the more significant event. The minutes relate to July’s decision to leave rates unchanged at 3.50%-3.75% and should provide further detail on the balance between officials concerned about lingering inflation and those increasingly comfortable with keeping policy unchanged.
GBP: Softer jobs market leaves inflation in the driving seat
Sterling is trading slightly softer following this morning’s UK labour-market report, with GBP/USD around 1.35 and GBP/EUR close to 1.17. The figures showed unemployment at 4.9% in the three months to June, while employment increased by 84,000 over the quarter. More timely payroll data were weaker, however, showing a 13,000 decline in payrolled employment during July.
Wage data offered a slightly more mixed picture. Regular earnings growth came in at 3.5%, while total pay increased 4.1%. Of greater significance for the Bank of England, private-sector regular wage growth slowed to 2.8%, its weakest rate since late 2020. Public-sector wage growth remained considerably stronger at 6.1%, although this continues to be distorted by the timing of NHS pay awards.
Overall, the report reinforces the picture of a gradually cooling labour market rather than a sharp deterioration. Sterling’s limited reaction reflects the fact that tomorrow’s inflation figures are likely to carry considerably more weight for the Bank of England outlook.
Consensus expects July CPI to rise by 0.4% month-on-month, taking the annual rate to 2.9% from 2.6%, with some forecasters looking for a 3.0% reading. Core inflation is expected to ease to around 2.5%. A stronger headline or services-driven result would increase the case for another Bank of England rate increase and could provide fresh support for sterling, while a softer print would reinforce the message from today’s labour data and leave the pound more dependent on continued dollar weakness.
Technically, GBP/USD continues to hold close to the 1.3500 area which previously capped the pair through much of the summer. Holding above that region keeps 1.3660 in view, while GBP/EUR remains supported above its rising 50-day moving average around 1.1660, with 1.1750 the next notable resistance level.
EUR: Rate expectations continue to support the recovery
The euro remains relatively well supported, with EUR/USD trading around 1.1570 after the recent decline in US rate expectations allowed the pair to recover from its July lows. Improving eurozone economic surprises and increasing expectations that the European Central Bank could tighten policy again in September have helped narrow a rate differential that previously favoured the dollar.
The immediate test comes from today’s German ZEW surveys. July’s expectations index jumped to 26.3, reflecting greater optimism about the outlook despite a still-weak assessment of current economic conditions. A continuation of that improvement would reinforce the view that Europe’s growth outlook is becoming less of a disadvantage relative to the US.
Higher energy prices remain the principal risk. Europe is considerably more exposed to imported energy costs than the US, meaning a prolonged disruption around the Strait of Hormuz could eventually weigh on activity and complicate the ECB’s inflation outlook even if the immediate FX reaction remains limited.
Technically, EUR/USD is sitting around its 100-day moving average near 1.1570. A sustained close above that area would strengthen the recovery and bring 1.1600 into focus, followed by the June high around 1.1655. Failure to hold the breakout would shift attention back towards support around 1.15.
Looking ahead
US housing and production — Tuesday: Housing starts are expected to fall to around 1.35 million annualised from 1.43 million in June, while industrial production is expected to rise by around 0.2% month-on-month. Further weakness would reinforce the recent decline in US economic surprises and could keep pressure on the dollar.
UK CPI — Wednesday: Headline inflation is forecast to rise to 2.9% year-on-year and 0.4% month-on-month, while core inflation is expected around 2.5%. A reading around 3% or above would strengthen the argument for another Bank of England rate increase.
Federal Reserve minutes — Wednesday: The minutes from July’s meeting will be watched for the degree of support for further tightening. Recent softer US data have reduced expectations for another near-term increase, leaving the dollar sensitive to any unexpectedly hawkish discussion.
UK PMIs — Friday: The flash composite PMI is forecast to ease to around 51.5 from 52.2, which would still indicate modest economic expansion. A stronger reading would support the view that recent UK growth resilience can continue.
Eurozone PMIs — Friday: The composite PMI is expected to fall to around 51.4 from 52.0, with services at 51.0 and manufacturing around 51.5. A sharper deterioration would test current expectations for further ECB tightening.
US PMIs — Friday: Manufacturing is forecast around 53.7 and services at 53.9, compared with 53.9 and 54.6 respectively in July. Another downside surprise would add to evidence that US exceptionalism is fading and could extend the dollar’s recent weakness.