Smooth Sailing After the Storm?

In just three weeks, approximately $6.4 trillion has been wiped from global stock markets due to rising fears of a US recession, disappointing AI-driven earnings from Big Tech, and a significant unwind of carry trades, leading to a more than 10% appreciation of the Japanese yen. The US dollar showed mixed performance, benefiting from safe-haven flows yet weighed down by concerns over weaker growth and high-yield appeal.

Deutsche Bank’s FX Volatility Indicator shows currency volatility has surged to levels last seen in October 2023, exceeding its 5-year average. Despite this, broader financial markets are showing signs of stabilizing today. Japanese equities have rebounded, leading gains in Asia as they recover some of the 12% losses from Monday’s global rout. Additionally, Euro Stoxx 50 futures and US equity futures have advanced, while Treasury yields have fallen. 

In the Treasury market, heightened demand pushed two-year yields, which are sensitive to monetary policy, below those of the 10-year note for the first time in two years. This briefly caused the US yield curve to turn positive for the first time since July 2022, after being inverted for a record duration. Typically, the yield curve steepens back above zero around the onset of an economic slowdown. However, both yields and equities recouped some losses yesterday afternoon after the US ISM services PMI exceeded expectations, driven by a rebound in new orders and the first rise in employment in six months.

Consequently, an off-cycle rate cut by the Federal Reserve appears even less likely. It seems more prudent for policymakers to wait until the September meeting to implement a 25 or even 50 basis point easing, depending on incoming data. Nonetheless, market nervousness might keep the US dollar strong, particularly against emerging market currencies.

Pound Steadies Alongside Equities

Thanks to stabilising equity markets and improving risk sentiment following Monday’s turmoil, the British pound has maintained its grip on the $1.27 support level against the US dollar, staying above key moving averages. Further bolstering sterling, UK retail sales rose 0.3% on a like-for-like basis in July compared to a year ago, reversing a 0.5% decline in June and aligning with market expectations.

This return to growth was largely driven by consumer purchases of clothing and beauty products in preparation for the holidays, as the late arrival of British sunshine boosted spending. Additionally, the final services PMI for July was revised slightly higher, marking the ninth consecutive month of expansion in the UK services sector. These recent improvements in economic activity coincided with the Bank of England beginning to cut interest rates, raising expectations for stronger underlying spending growth in the second half of the year.

While this should support the British pound in the longer term, rate differentials suggest sterling might be overstretched, especially against the euro. As a result, it's not surprising to see GBP/EUR stuck below €1.17, with the pair having dropped over 2% in just a few trading sessions.

Euro has finally found support

The euro has found support from a softer US outlook, rallying to an 8-month high amid safe-haven and positioning unwind flows. Although the pair briefly surpassed the $1.10 threshold, it quickly lost momentum following a better-than-expected US ISM report. This rally has reduced the euro’s year-to-date losses to approximately 0.7%, making it the second-best performer among G10 currencies, just behind the GBP. If the US soft landing scenario faces further skepticism, the euro could climb higher. However, the rally is unlikely to be sustained as weaker global growth does not favour the pro-cyclical euro.

The global stock correction has triggered a rush into Treasuries and European bonds. German 2-year yields dropped almost 20bps in early Monday trading, marking the most aggressive European bond rally since the French snap election announcement. The German front end is trading as though the European Central Bank is poised to cut interest rates imminently. At one point, traders were betting on as many as 42bps of ECB cuts in September and 94bps of cuts by year-end. Rate cut expectations have since stabilized to Friday’s levels, with 26bps anticipated for September 2024 and 77bps by December 2024. The BTP-bund and OAT-bund spreads widened by 7bps and 4bps, respectively, as fears of a global recession grow.

Elsewhere, the euro remains under pressure from safe-haven flows. EUR/CHF depreciated for the sixth consecutive day amid risk-off sentiment, pushing the spot rate near 2024 lows. The euro also posted another single-digit loss against the Japanese yen due to the continued unwind of short yen positions. The options market shows clear signs of heightened market stress. All G10 euro crosses exhibit an inverted implied volatility term structure, with implied volatility for tenures up to 4 months exceeding those on longer tenures. EUR/JPY implied volatility structure is now entirely in backwardation. EUR/USD 1-week risk reversal saw the sharpest single-day bullish repricing in two years last Friday, with the skew currently at 0.373 vol in favour of calls.