China’s Economic Struggles Persist
The cyclical segment of China’s economy remains under pressure due to fiscal limitations, weak domestic demand, and anticipated higher tariffs. Loan growth hit a record low in July, paralleling the unprecedented drop in Chinese bond yields across the curve. August didn’t fare any better, with the official composite PMI falling to its lowest point since December 2022. The manufacturing index stayed in contraction for the fourth month in a row, with all sub-components dipping below the 50 mark last month. This phenomenon has only occurred 12 times since 2005, all post-pandemic. The week’s first data release came from China, shifting focus to the US PMI for manufacturing, which will influence FX markets.
Seasonal Factors Could Impact Sterling
Sterling started September positively, bolstered by the final UK manufacturing PMI for August, which showed UK factory activity growing at the fastest rate in over two years. This marked the fourth consecutive month of expansion, suggesting a continued economic recovery in the UK for Q3.
This positive result starkly contrasted with the declining manufacturing activity across Europe. The Eurozone’s manufacturing PMI confirmed the sector remained in contraction in August, dragged down by Germany and France. The UK’s better-than-expected economic data, along with cautious comments from Bank of England (BoE) Governor Bailey on further rate cuts, have reduced expectations for UK rate cuts. Markets are now pricing in just 40 basis points of rate cuts from the BoE by year-end, compared to 60bps from the ECB. Consequently, the EUR/GBP 2-year swap rate gap has widened to its largest since February, favouring sterling. As a result, GBP/EUR remains strong just under €1.19, over three cents above its 5-year average.
However, after three consecutive weekly gains, GBP/EUR might lose momentum. Seasonal trends are negative for sterling, as September has historically been the worst month of the year for the pair since 2000. A significant decline would require a substantial increase in BoE easing expectations, making next week’s UK labour market data and the following week’s inflation data critical.
Political Uncertainty Rises in Europe
After climbing to a one-year high above $1.12 last week, EUR/USD lost momentum and settled back into the $1.10 range. The impact of Fed-driven dollar weakness appears to be largely priced in, and the yield-driven bullish case seems to have lost steam as ECB rate-cut discussions resurface following last week’s Eurozone inflation report, which hit a three-year low. Additionally, rising political risk in Europe is seen as a challenge for the common currency.
In France, the search for a premier remains unresolved, while over the weekend, populist parties on the extreme right and left made significant gains in German regional elections. Germany’s euro-sceptic party, Alternative for Germany (AfD), celebrated a major victory in the eastern state of Thuringia – its first state parliament win since World War Two. AfD also came a close second in the more populous neighbouring state of Saxony. With federal elections only a year away, the AfD is second in national opinion polls, potentially prompting calls for early elections. Given the earlier turmoil in France this year, investors might become cautious about the implications for European assets, including the euro.
Indeed, EUR/USD one-month risk reversals have turned negative again, indicating a rising premium to protect against a decline in the common currency.
