All Eyes on Key US Data
The US dollar has continued its recent recovery as yields on two-year and 10-year bonds climbed to their highest levels in weeks. This move was driven by Federal Reserve Chair Jerome Powell’s slightly hawkish tone, alongside robust US economic data. Additionally, safe-haven demand for the US dollar, prompted by the escalating conflict in the Middle East, has further buoyed the currency.
In the short term, the dollar’s bullish momentum is expected to persist, underpinned by weakness in other major currencies and ongoing haven demand. The US’s economic strength is also providing support, with the ISM services PMI rising at its fastest pace since February 2023. Nonetheless, the dollar’s longer-term trajectory still leans lower amidst the global easing cycle. Despite this week’s data causing traders to scale back expectations of Fed rate cuts, the odds of a half-point cut in November remain around 65%. Although further cuts are priced in more aggressively for the Fed compared to the ECB and BoE, this could cap the dollar’s gains. However, if yields remain elevated despite rate cut expectations, the dollar could stay supported through November. Market sentiment is also shifting; FX options traders are now the most bullish on the dollar since July, though upcoming US payroll data could change the narrative once again.
Today’s jobs report may well be the pivotal factor determining the Fed’s decision next month. A below-consensus non-farm payrolls figure could see markets price in a greater chance of a substantial 50bp cut in November, thereby weakening the dollar. Conversely, a stronger-than-expected print would support the argument for a more modest 25bp cut, putting the dollar index on track for its strongest week since April.
Bailey’s Comments Send the Pound Reeling
The pound has been hit by a triple whammy of risk aversion, strong US data, and dovish remarks from the Bank of England (BoE). Increased demand for safe-haven assets due to geopolitical tensions, coupled with the pound’s sensitivity to risk, delivered the first blow to GBP/USD. Stronger US data and hawkish signals from the Fed gave the dollar an additional edge. However, the knockout punch came from BoE Governor Bailey, who hinted at a more aggressive approach to rate cuts if inflation continues to ease.
GBP/USD is set for its largest weekly decline since July 2023, having dropped around 1.7% so far. Money markets now fully price in a 25bp cut in November and a 70% chance of another in December, up from around 40% earlier this week. Six rate cuts, up from five, are now priced in by the end of 2025. We have been vocal about the disconnect between BoE pricing and that of its peers, viewing a dovish recalibration as the primary risk to sterling’s outlook. The pound fell by over 1% against both the dollar and the euro following Bailey’s comments, with GBP/EUR posting its worst day since 2022. With bullish GBP positions becoming crowded, the risk is that the pound could decline more sharply if these positions unwind. Sentiment in GBP options has already turned the most bearish since mid-August.
Will the BoE’s Chief Economist, Huw Pill, offer any support for the pound today? Pill, who was one of the dissenters at the August BoE meeting in favour of holding rates, could temper Bailey’s recent dovish tone. However, for the pound to truly recover, a combination of positive UK economic data and a de-escalation of Middle Eastern tensions would be required.
Euro Erases Year-to-Date Gains
The broad euro index has rebounded from three-week lows, supported by upward revisions to the Eurozone services and composite PMIs. Gains of over 0.4% against both the NZD and AUD were bolstered by cautious market sentiment amid the ongoing Israel-Iran conflict, while the pound’s weakness following dovish comments from BoE Governor Bailey led EUR/GBP to surge nearly 1% on Thursday. Nonetheless, EUR/USD remains under pressure as diverging rate expectations continue to weigh on the pair. Market participants have pared back bets on Fed rate cuts, while expectations for an ECB rate cut at its October meeting have increased, putting additional pressure on the euro.
The Eurozone composite PMI was revised higher to 49.6 in September, up from an initial estimate of 48.9, but it still entered contraction territory for the first time since February. While the services sector slowed (51.4 vs 52.9) and manufacturing contracted further (45 vs 45.8), demand for goods and services in the euro area fell at its fastest pace in eight months, leading to backlog reductions and an accelerated rate of job cuts. Business confidence has also softened slightly.
As a result, European equities have declined for the fourth consecutive day, with month-to-date losses approaching 3%. Meanwhile, implied EUR/USD volatility rose to a two-week high ahead of the US non-farm payrolls report. Short-term risk reversals now favour euro puts, reflecting the most bearish sentiment since early August. Unless US jobs data disappoints, the euro is likely to continue its decline, reflecting the region’s ongoing weak fundamentals.
