Yesterday, despite a decrease in US Treasury yields, the US dollar strengthened as markets analysed mixed signals from US policymakers and economic data regarding the Federal Reserve's interest rate trajectory. Neel Kashkari, President of the Minneapolis Fed, hinted at the possibility of the Fed refraining from rate cuts this year due to persistent inflation, even suggesting a potential rate hike.
At the start of the year, there was enthusiasm about the anticipated magnitude of Fed rate cuts in 2024. However, markets may have overcorrected, with some estimating a 25% chance of no cuts this year. Powell's cautious remarks during a press conference, coupled with a softer US jobs report last week, reduced this probability by half. Although the US economy continues to grow steadily, recent disappointments in purchasing manager indicators and a drop in small business confidence to an 11-year low, alongside moderating job growth, have cast doubt on the narrative of US exceptionalism. The US economic surprise index has reached its lowest level since early 2022, mildly impacting the dollar. Nonetheless, if inflation in the US continues to rise, the expectation that the Fed will maintain higher rates compared to other central banks will uphold the US currency.
Investors are now awaiting further insights from central bank officials and Friday's Michigan Consumer Sentiment Index for a clearer picture of the rate trajectory. The current likelihood of a rate cut in September stands at approximately 67%.
GBP/USD ended a four-day winning streak, slipping below its 200-day moving average and the psychologically significant $1.25 level as traders await the Bank of England’s (BoE) rate decision on Thursday. Yesterday, the pair experienced a downturn as UK bonds saw significant gains once the Gilt market reopened following the UK bank holiday. Traders increased their bets on the extent of BoE easing anticipated for this year.
Anticipation of BoE interest rate cuts is driving up demand for UK Gilts. Particularly, the long end of the yield curve is performing well, with the 10-year yield dropping to its lowest point in three weeks, consequently pulling down GBP/USD. Based on swaps, traders anticipate approximately 55 basis points of cuts through 2024, roughly equivalent to two rate cuts. Our assessment suggests that inflationary pressures in the UK are likely to diminish more swiftly than commonly assumed, potentially paving the way for the BoE to implement rate cuts as soon as June and potentially more aggressively throughout the year compared to market expectations. However, as long as the global trend towards policy easing continues, the downside risk for sterling against the US dollar should remain limited.
However, the situation could be different against the euro. In fact, one-month euro-sterling risk reversals have reached a six-month high, indicating bearish bets on the UK currency. This suggests that more traders are hedging against the risk of the pound depreciating against the euro rather than appreciating.
