British Economy Expands in August, But Pound Faces Headwinds
The British economy grew by 0.2% in August, rebounding from zero growth in July, in line with market expectations. Despite this positive economic data, the pound has shown little to no reaction. After appreciating against 70% of its global peers in September, the pound has only gained against 16% of them so far in October. The primary drag on the currency has been a dovish repricing of Bank of England interest rate expectations, although UK bond yields have risen to their highest levels since July, likely in response to higher US yields and anticipation of the upcoming UK Budget at the end of the month.
Additionally, the rise in oil prices and increased demand for safe-haven assets due to escalating tensions in the Middle East have further limited demand for risk-sensitive currencies, including the British pound. Energy-importing nations like the UK have been particularly impacted. However, the euro appears even more vulnerable, as reflected by the pound's modest 0.7% decline against the euro this month, compared to a larger 2.5% drop against the US dollar. With the dollar benefiting from safe-haven flows ahead of a tight US election, GBP/USD downside risks are increasing, and a break below $1.30 could signal further declines. A Republican victory in the US elections poses a significant risk to the pound, given its strong correlation with risk sentiment and the dollar's likely short-term rally in such a scenario.
Mixed US Economic Data Fuels Fed Rate Cut Speculation
Market participants evaluated a slightly higher-than-expected US inflation report alongside a worse-than-expected jobless claims figure. The contrasting data signals ongoing uncertainty in the tug-of-war between the labour market and inflation. However, the overall market reaction saw an increase in bets on a potential quarter-point rate cut by the Federal Reserve in November. This shift led to the largest daily drop in two-year US Treasury yields for the month, while the US dollar index marked its ninth consecutive day of gains.
US Election Uncertainty Drives Hedging Costs and FX Volatility
Markets have begun factoring in the risks surrounding the upcoming US election, leading to increased hedging costs and heightened foreign exchange (FX) volatility. The tight race between Trump and Harris has become too close to predict, with polls and betting markets fluctuating within the margin of error. As the November 5 election approaches, market price swings are expected to continue as shifting implied winning probabilities lead to constant repricing. A lean towards Trump in betting polls could boost the US dollar, while a rise in support for Harris may relieve some pressure on emerging market currencies.
French Budget Constraints and ECB Expectations Weigh on Euro
While not the primary factor behind the euro's recent weakness, French budgetary constraints have added to the downside pressure on the currency. The European Central Bank has signalled that next week’s October meeting is "live," with markets anticipating a 25 basis point cut in benchmark policy rates. Meanwhile, expectations for a Federal Reserve rate cut have diminished, causing the rate differential to move against the EUR/USD pair. As a result, the currency pair is likely to close the week below the $1.10 level after remaining above it for seven consecutive weeks.