Inflation lands as bond yields take centre stage
Market overview
FX markets begin Wednesday with the dollar still under pressure, sterling showing little reaction to this morning’s UK inflation figures and global bond yields becoming an increasingly important risk for currencies. The dollar index is hovering around 99.65, close to recent multi-month lows, while EUR/USD trades near 1.1580 and GBP/USD remains around 1.3540. Softer US economic data have reduced expectations for another Federal Reserve rate increase, leaving tonight’s FOMC minutes as the main immediate test for the dollar.
The bigger cross-market story is the continued rise in long-term government borrowing costs. The US 30-year Treasury yield reached 5.337% on Tuesday, its highest closing level in 19 years, while the UK equivalent is approaching 5.8%. Brent crude has also climbed above $91 a barrel as uncertainty over the Strait of Hormuz persists. Higher energy prices, elevated government borrowing and concerns over longer-term inflation are combining to push yields higher even as expectations for near-term central-bank tightening have eased.
USD: Fed minutes test the dollar’s softer tone
The dollar remains on the defensive after a run of weaker US data encouraged investors to reduce expectations for another Federal Reserve increase in September. Softer inflation and payroll figures have been followed by disappointing retail activity and signs of weakness within industrial production, leaving the picture of US exceptionalism less convincing than it appeared earlier in the summer. Convera estimates that the probability of a September increase has fallen from around 70% to closer to 40%.
That shift helps explain why the dollar has struggled to benefit from the rise in long-term Treasury yields. The 30-year yield reached its highest level since 2007 on Tuesday, but much of the move appears to reflect fiscal concerns, inflation uncertainty and increasing bond supply rather than expectations for significantly stronger US growth. Ten-year yields have eased back towards 4.69% this morning, providing further evidence of a disconnect between the longer-term bond sell-off and the near-term Fed outlook.
Tonight’s Federal Reserve minutes will therefore be closely watched. July’s meeting produced a 9-3 vote to leave the target range unchanged at 3.50%-3.75%, with three policymakers preferring a quarter-point increase. The minutes should reveal how broadly concerns about persistent inflation were shared across the committee and how close other policymakers were to supporting higher rates.
However, the meeting took place before the latest softer employment, inflation and activity data. That reduces the value of an aggressively hawkish interpretation of the minutes: markets may view any support for higher rates as partly overtaken by events. A softer discussion would reinforce the recent decline in Fed expectations and leave the dollar vulnerable to further selling, while evidence that a larger group of policymakers was considering an increase could offer the currency some short-term support. The minutes are released at 2pm Eastern time, or 7pm BST.
GBP: Inflation fails to shift the outlook
Sterling has been relatively unmoved by this morning’s UK inflation report. Headline CPI rose to 2.9% year-on-year in July from 2.6% in June, matching consensus expectations and reaching a four-month high. Monthly inflation was 0.3%, while core CPI held at 2.6%, slightly above the 2.5% expected by economists. The rise in headline inflation was largely driven by energy, following a 13% increase in the household energy price cap.
More encouragingly for the Bank of England, services inflation eased to 3.4% from 3.6%. Combined with yesterday’s softer wage figures and signs that the labour market is cooling, the data provide relatively little evidence of a renewed build-up in domestic inflation pressure. Markets appear to agree: expectations for a September Bank of England increase actually fell after the release, with the implied probability slipping to around 18% from 27% beforehand.
GBP/USD continues to trade around the mid-1.35s, while GBP/EUR remains close to 1.1690. The pound’s limited response reinforces the view that global factors are currently having more influence than domestic data. HSBC has also questioned whether current rate expectations are too supportive of sterling, noting that markets are pricing two Bank of England increases through late 2026 and early 2027 despite policymakers showing little urgency to tighten. A weaker economy and softer labour market could ultimately make those expectations difficult to deliver.
The greater near-term risk may instead come from the gilt market. Thirty-year UK borrowing costs are close to 5.83% and approaching the psychologically important 6% level, last seen in the late 1990s. The UK is particularly exposed to a global rise in long-term yields because of its heavy borrowing requirement, large stock of inflation-linked debt and sensitivity to energy-driven inflation. Sterling has historically responded poorly when gilt yields rise because of concerns over fiscal sustainability rather than improved economic prospects, making this an increasingly important indicator to watch.
EUR: Recovery struggles to find another gear
EUR/USD remains close to 1.1580 and near the two-month highs reached earlier this week, benefiting from the reduction in US rate expectations but struggling to generate a decisive move of its own. The pair remains close to its 100-day moving average around 1.1568, with 1.1600 the next important resistance level and the June high around 1.1655 beyond it. Holding above the moving average would strengthen the technical recovery, while a move back below 1.15 would weaken the recent improvement.
Eurozone inflation is also in focus later this morning, although the final July release is unlikely to generate significant volatility unless it revises the earlier estimate. The preliminary figures showed headline inflation rising to 2.9% from 2.8%, with core inflation increasing to 2.5%. Energy inflation reached 10%, highlighting the effect the Middle East conflict continues to have on the region’s price outlook.
The ECB’s increasingly hawkish bias and improving eurozone economic data have helped make relative rate expectations more supportive of the euro. However, that has yet to translate into a convincing EUR/USD breakout. Oil prices have risen around 3% this week and remain close to $90-$91 a barrel, creating a potential drag on the region through higher import costs. At the same time, France’s 30-year borrowing costs have risen to their highest level since 2008 as fiscal and political concerns return to focus.
Friday’s flash PMIs may provide a clearer test of the eurozone growth story. July’s composite PMI rose to 52.0, but consensus expects it to ease to around 51.4 in August as higher energy prices begin to weigh on activity. A resilient release would support the case for further ECB tightening and improve the chances of EUR/USD clearing 1.16, while a sharper slowdown would leave the recent recovery increasingly dependent on further dollar weakness.
Looking ahead
Eurozone inflation — Wednesday: Final July CPI is expected to confirm the preliminary 2.9% annual headline rate and 2.5% core rate. A meaningful revision would influence expectations for another ECB increase, although an unchanged reading should have limited market impact.
Federal Reserve minutes — Wednesday: July’s meeting ended with a 9-3 vote to hold rates at 3.50%-3.75%. Markets have reduced the implied probability of a September increase to around 40%, making the balance of opinion within the committee particularly important for the dollar.
UK PMIs — Friday: The flash composite PMI is expected to ease to around 51.5 from 52.2. A reading comfortably above 50 would support the view that UK growth remains resilient despite a softer labour market, while a downside surprise would strengthen the case for the Bank of England to remain on hold.
Eurozone PMIs — Friday: The composite PMI is forecast to fall to 51.4 from 52.0, with services expected around 51.0 and manufacturing near 51.5. The figures will provide an early indication of whether higher energy costs are beginning to undermine the region’s recent improvement.
US PMIs — Friday: Manufacturing is forecast at 53.7, down slightly from 53.9, while services are expected at 53.9 versus 54.6 previously. Another downside surprise would reinforce the recent deterioration in US economic momentum and could keep the dollar under pressure.
Bond yields and oil: The UK 30-year gilt approaching 6%, the US 30-year Treasury trading above 5.2% and Brent crude above $91 are becoming increasingly important cross-market risks. A disorderly extension of the bond sell-off could begin to have a much greater influence on FX, with sterling potentially among the more vulnerable major currencies.