Markets Brace for Policy Shifts and Oil Supply Concerns

Markets are still grappling with the complexities of President-elect Donald Trump’s policy proposals, with investors closely monitoring developments from his incoming administration. Meanwhile, oil prices surged over 3% on Monday, marking the largest daily gain since early October. The rally was driven by the U.S. authorizing Ukraine to deploy long-range missiles within Russia and a production halt at Norway’s Johan Sverdrup oilfield—Western Europe’s largest—following an onshore power outage, intensifying fears of supply constraints in the North Sea crude market.

ECB Policy Bets Shift Amid Trade Tensions and Euro Gains

Traders have scaled back expectations for policy easing by the European Central Bank (ECB) in the coming year, with options markets now pricing in 135 basis points of rate cuts through the end of 2025, down from 147 basis points last week. This adjustment reflects growing concerns about the potential impact of Donald Trump’s proposed tariffs on European goods, which could heighten the risk of an economic downturn in 2025 and 2026 while fuelling another wave of inflation.

The interplay between growth, inflation, and trade tensions adds uncertainty to the ECB’s outlook, potentially prompting a flexible policy response to navigate the unpredictability of a new trade spat. The euro has benefited from the repricing, strengthening for a second consecutive day against the US dollar—a milestone last seen three weeks ago. German Bundesbank President Joachim Nagel emphasized that trade-related inflation spikes might necessitate higher interest rates.

EUR/USD has moved further from the $1.05 level, nearing $1.06. However, short-term market sentiment remains bearish, with the 1-month delta risk reversal dropping to its lowest point since July.

Pound Mixed as Markets Eye BoE Testimony and Policy Uncertainty

The pound had a mixed start to the trading week, losing ground against pro-cyclical and high-beta currencies but gaining against safe havens. GBP/USD remains supported by ongoing USD profit-taking, with the pair nearing the $1.27 level. However, reduced expectations for Federal Reserve easing and uncertainty surrounding the Bank of England’s (BoE) policy stance could limit further gains.

BoE Governor Andrew Bailey and other policymakers are set to testify before Parliament’s Treasury Committee on inflation and the economic outlook. Their remarks could significantly shape market expectations regarding future interest rate cuts, influencing GBP/USD movements. Current market pricing suggests only a 15% chance of a BoE rate cut next month, with just over two cuts anticipated by this time next year. Meanwhile, pound options traders are preparing for higher volatility in 2024, driven by the U.S. presidential election outcome and rising trade and sentiment risks.

Fed Signals and Dollar Surge Shape Investor Sentiment  

Last week, investors were relieved when the Consumer Price Index (CPI) met expectations, alleviating fears that rising inflation would halt the Federal Reserve's plans to cut interest rates in December. However, on Friday, Fed Chair Jerome Powell struck a cautious tone regarding the pace of rate cuts, dampening the market's recent risk rally and tempering the optimism that had propelled U.S. equities to record highs.  

Meanwhile, the U.S. Dollar Index has surged approximately 7% over the past seven weeks, marking its strongest performance over such a period since 2022. Options trading activity and positioning data indicate traders are anticipating further gains in the dollar. Additional upside risk for the greenback may stem from key policy proposals by former President Donald Trump—particularly tariffs—that may not yet be fully reflected in current market prices.

Pound vs. Euro: UK Data Risks and Eurozone Headwinds  

The Pound Sterling may face further losses against the Euro in the coming week if UK inflation and PMI figures fall short of expectations. Last week, the Pound to Euro exchange rate (GBP/EUR) dropped 0.65%, despite hitting a two-year high of 1.21 at inter-bank (IB) on Monday, last week. This peak reflects a generally constructive outlook for the Pound against the Euro, supported by the UK's higher interest rates compared to the Eurozone.  

Broader euro weakness stems from political uncertainty in Germany and concerns about potential U.S. tariffs under a future Trump administration. In the near term, GBP/EUR appears to be consolidating its recent gains, with resistance at the 1.21 highs for 2024. On the downside, strong support is seen at 1.1850, aligning with the lows recorded in November, October, and September.

Key UK Inflation Data and Geopolitical Tensions to Shape Markets  

This week’s UK inflation data, set for release on Wednesday, will be a critical focus for markets. Inflation is expected to rise to 2.2% year-on-year in October, up from 1.7% in September, signalling an acceleration in price pressures.  

Adding to market dynamics is President Biden’s recent decision to authorise Ukraine to deploy U.S.-made long-range missiles for strikes deep into Russian territory. Geopolitical tensions like these often push investors toward safe-haven assets such as the U.S. dollar, potentially boosting its value further.

Dollar Flirts with New One-Year High

The US dollar index briefly reached a fresh one-year high on Thursday before pulling back sharply. This retreat came as little surprise, given the dollar had entered overbought territory, as indicated by the 14-day relative strength index surpassing 70. Even so, the index has climbed more than 6% over seven weeks, marking its most robust performance over such a period since 2022. Renewed risk aversion on Friday lent further support to the safe-haven dollar, while equity markets faltered after Jerome Powell hinted that the Federal Reserve sees no urgency to lower interest rates and expects PCE inflation to rise.

This week’s surge in the dollar was partly fuelled by President-elect Donald Trump’s hawkish cabinet appointments and the Republicans retaining control of the House, delivering Trump a political trifecta that heightens prospects for his policy agenda. Economic momentum had already shifted in favour of the US, prompting another hawkish reassessment of the Fed’s rate-cutting trajectory, which benefits the dollar via both fiscal-monetary and trade policy channels. Although expectations for sustained US growth into 2025 and Trump’s policies may outweigh seasonal dollar weakness through the year’s end, uncertainty remains significant. The critical issue now is the scale and pace of forthcoming policy changes.

On the data front, Wednesday’s CPI figures were complemented by PPI data signalling inflationary pressures in segments of the economy, which could constrain the Fed’s easing cycle. Core goods prices recorded their largest increase since February, further supporting projections for a rate cut in December. Overnight swaps reflect a 46% likelihood of this, with only two rate cuts anticipated over the next five Fed meetings.

ECB Rate Cut Fully Priced In

The euro has suffered five consecutive daily declines, falling to the mid-$1.05 range—the lowest level since October 2023. Minutes from the European Central Bank’s latest meeting strongly indicated policymakers favour further interest rate cuts, potentially as soon as December. Markets have priced in a 100% probability of policy easing. As inflation concerns fade, growth risks have become the dominant concern. Trump’s election, the prospect of tariff wars, and instability in Germany’s governing coalition have added to the challenges facing European policymakers.

The situation worsened in September, with industrial production recording its second-largest monthly drop this year, declining by 2%. Manufacturing production has shown annual growth in only one month since the start of 2023, highlighting the European industry’s struggles. Lower interest rates in 2024 are likely to be welcomed, but the euro faces continued downward pressure. Without a clear catalyst for recovery, bearish sentiment towards the currency is expected to persist.

UK Growth Stagnates Through Summer

The pound briefly rebounded from a four-month low near $1.26 to reach $1.27 before relinquishing some of its gains following disappointing UK GDP data. The economy contracted unexpectedly in September, resulting in just 0.1% growth for the third quarter.

The dominant services sector expanded by 0.1%, while construction grew by 0.8%. However, industrial production fell by 0.2%, painting a lacklustre picture for the new Labour government, which had pledged to achieve annual growth of 2.5%, the fastest in the G7. Compounding Britain’s economic challenges is the spectre of a new wave of protectionism following the US election. Nonetheless, the direct impact on the UK is expected to be minimal, given the US maintained a goods trade surplus of $10.5bn with Britain in 2023, with the UK accounting for just 2.1% of US goods imports.

Sterling faces an uphill battle to recover to $1.30 against the dollar, as tighter US monetary policy, driven by the inflationary effects of tariffs, continues to weigh on the currency. Additionally, sterling’s pro-cyclical nature makes it particularly sensitive to market volatility. With equities and cryptocurrencies losing momentum, safe-haven demand is likely to bolster the dollar, keeping the pound under pressure in the near term.

Power Shift Overshadows Inflation

Shortly after US inflation data sparked a rally in Treasury bonds and weakened the dollar, comments from Dallas Federal Reserve (Fed) President Lorie Logan reversed much of this effect, particularly for the dollar. Although Logan does not vote on monetary policy, she suggested the Fed should proceed cautiously with rate cuts due to inflationary pressures from robust demand and geopolitical factors. Meanwhile, Republicans have secured control of both the White House and Congress, providing President-elect Donald Trump with full authority over the elected branches of government.

US headline inflation rose in line with economists' expectations, increasing by 2.6%, up from 2.4% in September. The core Consumer Price Index (CPI) remained steady at an annual 3.3%. Despite persistent shelter costs, new rent indices indicate a slowing trend, with the annualised rate climbing 3.6% over the last three months, marking the quickest pace since April. The Federal Reserve will monitor this data closely, having already reduced its benchmark rate by 0.75 percentage points across two meetings, setting a target range of 4.5-4.75%. The probability of a further rate cut by the Fed in December rose to around 75% from 56% earlier on Wednesday, bolstering demand for short-term bonds and pushing yields lower. However, the Republican Party’s majority in the House is expected to make Trump’s agenda for tariffs and tax cuts easier to implement, helping the dollar reach a one-year high against a basket of currencies. Consequently, while Treasury yields on short-term bonds declined, the dollar strengthened, with the Fed on a defined path of rate reductions as Trump gears up for fiscal expansion.

Having climbed more than 6% over six weeks, attention is now on whether the dollar index can surpass 107, potentially paving the way for further gains, with 110 as a major psychological level. On the downside, strong support lies near the 200-day moving average around 104. Given the dollar’s impressive rally since October, momentum could start to fade, possibly leading to a pullback amid profit-taking.

Euro Breaks Below $1.06

The euro’s bearish outlook persists as the currency has fallen sharply below the significant $1.06 level against the US dollar. Investors have identified currencies likely to underperform under the Republican majority led by President-elect Trump, with the euro and yuan leading that list; the EUR/USD and CNY/USD pairs now show the highest 90-day rolling correlation on record.

The euro has depreciated by about 5% since late September, when markets began to price in a Trump presidency, pushing the EUR/USD pair into negative territory for the year. If this trend continues through December, it would mark the fifth time in seven years that the euro has weakened against the dollar. With less than two months left, currency investors will be watching for seasonal trends, Trump’s cabinet choices, and the results of Germany’s vote of confidence to assess the likelihood of EUR/USD reaching parity.

European economic data will need to show marked improvement to bolster the continent’s assets. Germany’s Council of Economic Experts, an independent advisory panel to the Chancellor, has downgraded its forecast for growth in Europe’s largest economy, which now appears set for its second consecutive year of contraction—a first since 2003.

Sterling’s Decline Deepens

The pound appears headed for its worst run since 2014 against the US dollar. GBP/USD has declined for six consecutive weeks and is poised for a seventh, marking a cumulative fall of over 5%. Since breaking below its long-term moving averages near $1.28, the downtrend has accelerated past $1.27, with the next support level found at the 100-week moving average of $1.26.

In line with other major currencies, sterling has been swept up in the dollar’s surge following the US election and Trump’s “red wave” victory, which posed a significant downside risk to GBP/USD. Domestically, UK inflation has dropped below the Bank of England’s (BoE) 2% target, although BoE officials remain cautious about ongoing pressures in the services sector and labour market. Catherine Mann, one of the more hawkish BoE policymakers, recently noted that the central bank can afford to hold off on rate cuts until there is clear evidence of easing inflationary pressures. Market expectations reflect this caution, with only a 16% chance of a BoE rate cut in December and just two quarter-point cuts fully priced in by the end of 2025—suggesting the BoE could lag other central banks in easing.

This relatively hawkish stance has been supportive for sterling in 2024, helping GBP/EUR reach over two-year highs near €1.21. However, downside risks remain if services inflation continues to decline, which could lead to a dovish reassessment and a negative impact on the pound. Mann further noted that she is prepared to “act boldly” on rate cuts when conditions warrant, which could catch markets, and sterling optimists, off guard.