Foreign Investors Adjust US Asset Holdings Amid Shifting Rate Cut Expectations
Foreign investors have been steadily increasing their holdings of US assets, expecting future rate cuts to drive yields lower. However, strong US jobs data has prompted investors to reduce these bets, which has, in turn, supported higher US yields and bolstered the dollar's rebound over the past week. Despite some dovish remarks from Federal Reserve policymakers, traders largely ignored them, with the market now pricing in just two rate cuts by year-end, down from three predicted just a few weeks ago.
Sterling Rallies Amid Oil Price Slump and Rising UK Yields
With oil prices dropping around 4% yesterday, the British pound rallied against G10 commodity-linked currencies like the Norwegian krone (NOK). While tensions in the Middle East have pushed oil prices up by over 15% in a month, increased output and demand concerns are acting as counterweights.
The pound, along with the euro, typically weakens when oil prices rise sharply due to the UK and many European nations being net importers of oil, which negatively impacts their terms of trade. This dynamic could be significant if Middle East tensions continue to escalate.
Another key development is the rise in UK bond yields, with the 10-year yield hitting a three-month high above 4%. However, this hasn't strengthened the pound as expected. The yield gap between UK and German bonds is now the widest in over a year, driven by differing expectations for interest rate cuts and growing concerns over the UK's upcoming budget. Despite this, the GBP/EUR exchange rate remains close to €1.19, still reeling from its largest daily sell-off in two years after Bank of England Governor Andrew Bailey's dovish comments last week.
Global bond market fluctuations are largely influenced by changing expectations around US interest rates, but the rise in UK yields may also reflect growing speculation that the UK government will need to issue more debt to cover a fiscal deficit, dampening the pound's reaction to higher yields.
Euro Consolidates Amid Speculation of ECB Rate Cuts and Economic Uncertainty
The euro remains just below the $1.10 mark after experiencing its second-worst week of the year. Traders are increasingly expecting the European Central Bank (ECB) to cut interest rates by 25 basis points at consecutive meetings in October and December, potentially bringing the deposit facility rate down to 3% from its peak of 4%.
This dovish shift in policy expectations reflects the ongoing weakness in the German economy and falling inflation, which is now below 2% in most European countries. Notably, German ECB board member Isabel Schnabel recently adopted a less hawkish stance, focusing on growth pressures as the labour market cools. This builds further momentum for easing monetary policy.
Additionally, concerns about France's ability to meet the Maastricht guideline of a 3% budget deficit continue to weigh on the euro. The risk premium on French government bonds compared to German bonds remains near its highest level since 2017. These factors suggest a lack of strong domestic drivers for a further EUR/USD rally, although an upward move cannot be ruled out entirely.
Focus on US economic developments may still help limit the euro's downside, especially if weaker macro data or signs of disinflation emerge across the Atlantic. However, with the US election approaching, policy uncertainty remains high, likely keeping demand for the US dollar steady and the euro's movement range-bound until the political landscape becomes clearer.