FX markets turn defensive as sterling holds firm

Market overview

FX markets are opening the week with a sharper defensive tone. Sterling is holding firm on stronger UK growth and rising BoE expectations, while the dollar is strengthening, the euro is slipping and the yen remains vulnerable. Higher oil, rising bond yields and weaker equities are all pushing investors towards a more cautious stance.

The move is being driven by a combination of renewed energy disruption, softer global risk appetite and a more hawkish rates backdrop. Brent is up more than 2% after Saudi Arabia shut a major crude pipeline, while talks over temporary passage through the Strait of Hormuz have been postponed. Fresh concerns around AI investment are also weighing on technology shares and adding to broader equity weakness. In rates, strong US data and firmer inflation have increased expectations of a Fed hike this week, while the UK is also seeing a more hawkish repricing ahead of inflation data and the BoE. The euro remains exposed to higher energy costs, while the yen faces the risk that a fully priced BoJ hike fails to deliver enough to offset stronger US yields.

GBP: Stronger growth raises the pressure on the BoE

Sterling starts the week on firmer ground after the UK economy expanded by 0.4% month-on-month in July, comfortably beating expectations for a 0.1% contraction. Growth was led by professional services and IT, reinforcing the view that underlying activity is proving more resilient than expected.

Attention now turns to UK CPI, with inflation expected to rise to 3.1% from 2.9%. Combined with significantly higher oil prices since the BoE's July projections, a firm print would make it increasingly difficult for policymakers to maintain a neutral stance.

Markets have already moved towards a more hawkish outlook, although pricing for three hikes by April 2027 still looks aggressive given the softer labour market and limited evidence of broader inflation pass-through.

A hawkish hold from the MPC could provide sterling with another leg higher, particularly against the euro. GBP/EUR has already pushed towards 1.1650 following the stronger growth data and could extend higher if inflation surprises to the upside. GBP/USD remains around 1.35 to 1.3550, where domestic support is being offset by renewed dollar strength.

Fiscal sentiment will also become increasingly important as the Budget approaches. For now, the absence of a major deterioration in the UK fiscal story leaves sterling's relatively attractive G10 yield profile intact.

USD: Fed repricing restores the dollar's appeal

The dollar is benefiting from a rare alignment of supportive factors. Strong US employment data and hotter August inflation have driven a sharp repricing of Fed expectations, strengthening the case for a 25bp rate increase this week and pushing real yields higher.

That rates move is being reinforced by the external backdrop. Saudi Arabia has shut the East-West crude pipeline following drone attacks from Iraq, while talks aimed at securing temporary passage through the Strait of Hormuz have been postponed. Higher oil prices are lifting inflation concerns just as weaker equities are reviving demand for defensive assets.

The technology sector is adding to the deterioration in risk sentiment, with prominent industry figures calling for a slower pace of advanced AI development because of safety, cybersecurity and governance concerns. For markets, the immediate implication is greater uncertainty over the investment cycle and valuations in an already expensive part of the equity market.

A Fed hike accompanied by a firm inflation message would likely validate the recent move in yields and could extend dollar gains. It may also begin to restore the positive relationship between the dollar and Treasury yields, strengthening the greenback's ability to perform as a safe haven.

A return towards 99.50 to 100.00 in DXY remains realistic under that scenario.

One potential complication is President Trump's proposal for a $5,000 payment to Americans if Republicans win Congress in the midterms. Markets remain sceptical given both the political hurdles and fiscal implications, but any sign that substantial pre-election stimulus is becoming credible could increase the risk premium attached to US assets.

EUR: Energy pressure starts to outweigh ECB support

The euro held up better than expected last week despite the sharp rise in oil, helped by the ECB's hawkish rate increase. That resilience is now beginning to fade.

EUR/USD has slipped below 1.16 and is trading around its weakest level in a month as higher energy costs, softer global risk appetite and widening rate support for the dollar all work against the single currency.

Further ECB tightening offers only limited additional protection. Markets already price two more rate increases by April 2027, leaving relatively little room for a fresh positive rates surprise. At the same time, the eurozone remains particularly exposed to a sustained rise in imported energy costs.

Initially, higher oil can lift inflation expectations and support tighter ECB policy. Beyond a certain point, however, the growth and terms-of-trade impact becomes more important. That leaves the euro caught between a weaker domestic outlook and a stronger dollar.

With the Fed decision approaching, relative rate expectations are likely to remain the dominant driver. Unless oil retreats or risk sentiment improves materially, EUR/USD remains vulnerable to further downside.

JPY: BoJ hike may not be enough to support the yen

The Bank of Japan is widely expected to raise rates by 25bp on Friday, with markets effectively fully priced for the move. A surprise hold appears unlikely, while a larger 50bp increase remains an outside risk given the government's preference for supporting growth.

The bigger issue for the yen is that the expected BoJ move may already be fully reflected in pricing. A hawkish Fed decision two days earlier could encourage investors to rebuild USD/JPY long positions, particularly if the BoJ fails to signal a sufficiently aggressive path beyond this week's meeting.

Markets have also priced a December BoJ hike, raising the bar for policymakers to deliver anything meaningfully more hawkish. Expectations around a possible shift in GPIF portfolio allocation are another potential source of disappointment if no announcement emerges.

Short-term valuation measures suggest USD/JPY remains around 2.5% undervalued, although such metrics are less reliable at current levels. Even so, a move back towards 156 to 157 this week looks plausible if US yields remain firm and the BoJ delivers little beyond what is already priced.

Looking ahead

• UK CPI: Inflation is expected to rise to 3.1%, with a stronger reading likely to reinforce expectations of a more hawkish BoE.

• Federal Reserve: A 25bp hike and the tone of Chair Warsh's guidance will be central to the next move in the dollar and global yields.

• Bank of England: Markets will focus on whether the MPC begins to acknowledge the case for another rate increase.

• Bank of Japan: A 25bp hike is largely priced, putting greater emphasis on forward guidance and the possibility of further tightening.

• Oil and geopolitics: Further disruption around Saudi infrastructure or the Strait of Hormuz would favour the dollar while increasing pressure on the euro.

• Risk sentiment: Technology-sector weakness and uncertainty around AI investment could keep equities under pressure and maintain demand for defensive FX.