FX markets turn to jobs data as yen surges and sterling comes under pressure

Market overview

FX markets head into the end of the week with central bank expectations firmly back in control. The yen has been the standout performer as investors unwind carry trades and increase bets on further Bank of Japan tightening, while softer Federal Reserve expectations have taken some of the shine off the dollar. The euro has benefited from the move lower in the greenback, although positioning remains cautious, while sterling is facing a more difficult backdrop as rising UK borrowing costs, fiscal uncertainty and narrowing rate support weigh on sentiment. With US payrolls due today and several major central bank decisions approaching, volatility across the major currency pairs could remain elevated.

USD: Fed hike expectations lose momentum

The dollar came under further pressure yesterday as investors reassessed the likelihood of a Federal Reserve rate increase later this month.

Fed Governor Christopher Waller joined New York Fed President John Williams in highlighting a more contained underlying inflation picture outside energy. Those comments have helped push the market-implied probability of a September hike towards 50%, down from around 70% earlier in the week.

That shift has been particularly visible against the yen. USD/JPY extended its decline for a second session and is now trading close to 156, having fallen around 2.4% this week.

The yen's strength reflects a sharp change in Bank of Japan expectations. Markets are now close to fully pricing a 25bp increase at the 18 September meeting, with a further two hikes expected by April 2027. Investors have responded by reducing yen-funded carry trades, where historically low Japanese borrowing costs have been used to finance positions in higher-yielding currencies.

Further yen gains are not guaranteed. A sustained tightening cycle could conflict with Prime Minister Takaichi's preference for a supportive policy backdrop, leaving investors to judge not only the economic case for higher rates but also the political tolerance for them.

The Federal Reserve enters its blackout period on Saturday ahead of the 16 September decision, placing even greater importance on today's employment report and next week's inflation numbers.

GBP: Fiscal concerns challenge sterling support

Sterling is struggling to retain the support it has enjoyed from relatively high UK interest rates.

GBP/EUR fell to a two-month low yesterday, breaking more decisively below the 1.1650 to 1.1700 range that had contained the pair since late July. The move had no single catalyst, but the wider environment is becoming less favourable for the pound.

As other central banks move towards tighter policy, sterling's yield advantage is becoming less distinctive. The Bank of England is also viewed as one of the least likely major central banks to raise rates this month, with markets assigning only around a 15% probability to a September move, although a full increase remains priced by year-end.

The domestic fiscal picture is adding another layer of uncertainty. UK government borrowing costs have risen sharply, with two-year yields recently reaching 4.629%, ten-year yields 5.25% and thirty-year yields 5.89%. Higher oil prices and renewed inflation concerns have contributed to the global bond sell-off, but the premium attached to UK debt also reflects concerns over the country's fiscal position.

The new government therefore faces a difficult balancing act ahead of the October Budget. Spending ambitions remain significant, while the scope for raising revenue through the largest tax streams appears limited. Any policies perceived as inadequately funded could place further pressure on gilts and sterling.

For now, elevated UK yields may continue to offer the pound some support. The greater risk would be a disorderly rise in borrowing costs that forces the government towards spending restraint or undermines investor confidence in the UK's fiscal framework.

GBP/EUR is trading around 1.1657, while GBP/USD is near 1.3503.

EUR: ECB support builds but sentiment remains cautious

EUR/USD moved higher yesterday, establishing a firmer foothold above 1.16 as expectations for an imminent Fed hike were scaled back.

The European Central Bank remains on course for another 25bp increase next week, with markets pricing the move with near certainty following stronger-than-expected eurozone headline inflation.

Despite that supportive rate backdrop, investor sentiment towards EUR/USD remains guarded. Risk reversals have moved below zero across maturities, signalling increased demand for protection against renewed euro weakness relative to the dollar.

The challenge for the euro is that a more hawkish ECB has so far struggled to generate sustained upside. At the same time, concerns surrounding US fiscal policy and the longer-term credibility of the dollar continue to prevent the EUR/USD outlook from becoming one-sided.

A strong US payrolls report today could revive expectations for Fed tightening and put the 1.1570 to 1.1600 support area back under pressure. A weaker report could reinforce the recent dollar pullback and leave EUR/USD better supported ahead of next week's US inflation release.

Looking ahead

• US employment report: Today's payrolls data could determine whether expectations for a September Fed hike recover or continue to fade.

• Federal Reserve blackout: Policymakers enter their pre-meeting silence period on Saturday ahead of the 16 September decision.

• ECB decision: Markets are close to fully pricing a 25bp increase next week.

• US inflation: Next week's release could be decisive for the Fed if today's labour data fails to provide a clear signal.

• UK inflation: August CPI is due on 17 September and will be an important input ahead of the Bank of England decision.

• Sterling risk: UK gilt yields and fiscal headlines remain key drivers for GBP as the October Budget approaches.