Dollar Faces Mounting Pressure Despite Safe Haven Flows Amid Fed Rate Cut Expectations

Global FX traders are increasingly adopting bearish dollar strategies ahead of the September Federal Reserve (Fed) rate decision. Although recent risk aversion, fuelled by concerns over the AI sector and rising geopolitical tensions, has driven safe haven flows into the US currency, cushioning its decline, the dollar index remains on track for its worst month of 2024. This trend persists despite a modest rebound from 1-year lows, as growing signals suggest the Fed will cut rates in September. Meanwhile, US consumer confidence improved in August, with the index rising to 103.3 from 101.9, beating forecasts of 100.7. However, despite this six-month high, the labour market differential reading fell to its lowest level since March 2021. 

Concerns over the US labour market have overshadowed the narrative, but traders are still betting on a 25 or 50 basis point rate cut in September, with up to four 25 basis point cuts by year-end.

Pound Surges to Two-Year High as Bullish Sentiment Grows Amid Diverging Rate Expectations

The pound has surged beyond $1.32 against the US dollar, reaching its highest level in over two years. Options traders are increasingly bullish on the currency’s prospects for the next month, marking the most optimistic outlook since 2020. This sentiment is driven by a growing belief that the Federal Reserve (Fed) will cut interest rates more aggressively than the Bank of England (BoE).

Although the BoE has already reduced rates this year from 5.25% to 5.00%, market expectations indicate that the Fed will ease more rapidly. Currently, markets are pricing in around five basis points of easing from the BoE next month, compared to about 30 basis points for the Fed. For the rest of the year, the BoE is expected to cut less than 40 basis points, while the Fed is anticipated to reduce rates by 100 basis points. Reflecting this outlook, options traders have become increasingly bullish on the pound, with one-month risk reversals showing the largest spread in favour of sterling since the start of the pandemic.

BoE Governor Andrew Bailey has cautioned that monetary policy will need to remain restrictive for an extended period, indicating that the easing cycle will be gradual. His remarks suggest a sustained divergence between US and UK rates, which is likely to continue supporting sterling.

European Markets Stagnate Amid Thin Trading; Euro Faces Pressure Ahead of Key Inflation Data

Tuesday saw little movement across European markets, with trading volumes remaining thin. Equity markets ended the day largely unchanged, and bond yields showed minimal variation. However, the broader Euro index closed in the red as concerns over weakening domestic fundamentals grew, while the EUR/USD pair edged down to $1.116 as month-end flows influenced the forex market. The euro's recent rally above $1.12 may have peaked, with technical indicators pointing to a potential pullback.

Investors are becoming increasingly cautious ahead of Friday’s release of Eurozone inflation data for August, which could significantly impact the European Central Bank's (ECB) monetary policy. Inflation in Germany and the wider Eurozone is expected to drop to its lowest level in over three years. Despite ECB officials signalling a cautious approach to rate cuts, markets are still pricing in about 65 basis points of cuts by year-end.

Meanwhile, the EUR/CHF pair fell nearly 0.5%, hitting a three-week low due to safe-haven outflows. In France, political tensions resurfaced as President Macron faced difficulties in forming a new government. After four days of discussions with party leaders, Macron ruled out forming a government with the left-wing Nouveau Front Populaire (NFP) alliance, citing the need for “institutional stability.” If a new government isn’t formed, a budget led by caretaker PM Gabriel Attal could result in €10 billion in cuts, which falls short of Brussels’ expectations. This uncertainty widened the OAT-Bund 10-year spread to 73 basis points, up 2 basis points from the previous day, adding further pressure on the euro.