Geopolitics Driving Markets

Global markets are processing mixed developments from Japan and the Middle East, which have kept the US dollar trading within a narrow range as the week opens.

In Japan, the ruling coalition has, for the first time in 15 years, lost its majority in parliament. This setback comes as voters focus sharply on soaring inflation and recent political scandals. The USD/JPY pair rose by approximately 1% following some loss of momentum in the US session, yet remains on course for a fifth consecutive weekly gain.

Tempering the dollar’s gains is the reduction in Middle Eastern tensions, after a previously anticipated Israeli retaliatory strike did not target Iran's oil and nuclear facilities. Consequently, Brent crude has declined around 13% from its peak in early October, as investors turn their attention to the upcoming US elections, the non-farm payrolls report, and the next Federal Reserve policy decision.

Could the US Election Defy Economic Precedents?

Market sentiment is shifting, with a higher probability now priced in for a Trump victory. Voters continue to regard inflation as the most pressing issue, followed by immigration and overall economic health. Each of these concerns remains intricate and nuanced, which is keeping poll results within a narrow margin of error.

Since 1929, no incumbent party has lost an election if the US economy avoided a recession in the preceding two years. Superficially, this trend appears to favour the current administration, yet two key factors complicate the outlook. First, while the US did experience two consecutive quarters of contraction in 2022, this so-called "phantom recession" was not formally classified as such by the NBER. Second, approximately 60% of voters describe the US economy as poor, a perception largely fuelled by inflation, which may limit the Democrats' economic advantage.

Major US Jobs Data Kicks Off "Jobs Week"

Shifting focus away from geopolitics, the US economic calendar features crucial labour market data this week, although its impact may be moderated by other market drivers.

The series begins tonight with the JOLTS report, measuring job openings and labour turnover, with market expectations suggesting openings will hold steady at around 8 million. With the US dollar strongly supported throughout October, any further robust data points may contribute to additional greenback gains.

Pound Sterling has been trending upward against the Euro, though the near term may see more fluctuations and uncertain movement. Recently, the GBP/EUR exchange rate has hovered around the nine-day moving average, as investor interest in buying or selling fades whenever the rate deviates too significantly. The 9-day moving average currently sits around 1.20, a significant psychological barrier that GBP bulls have struggled to break. Previous analysis suggested that selling pressure around the 1.2030–1.2050 range becomes pronounced due to retail interest, as this level allows providers to offer euro buyers the attractive 1.20 mark. Consequently, speculators aware of this dynamic tend to sell in this range, which limits further strengthening of Pound Sterling.

Near-term developments may be impacted by external economic factors, including Friday's U.S. jobs report and the upcoming U.S. presidential election. GBP/EUR is notably responsive to global investor sentiment and often experiences pressure when stock markets decline. Currently, both stock markets and the Pound-Euro rate are in a bull run, reaching two-year highs over recent months. This trend could continue toward the year-end, though a strong U.S. jobs report may introduce volatility, potentially bringing GBP/EUR below 1.20 by week’s end. While speculation about the U.S. election outcome is abundant, analysts do not foresee a major impact on the GBP/EUR rate. In general, market expectations favour a stable election outcome, which may support continued GBP strength through the end of the year.

Key domestic events will also shape GBP movements, with the UK budget announcement expected on Thursday. The market anticipates a challenging budget for businesses and investors, with potential tax rises posing risks to UK growth. However, it is likely to be an expansionary budget, given the Chancellor's revised fiscal rules to allow for increased borrowing intended to fund growth-boosting projects. Analysts estimate these investments could raise growth by 0.5% in 2025, a development which could lead the Bank of England to approach rate cuts cautiously, supporting GBP in the longer term. Although increased borrowing could raise concerns in the market, reminiscent of the reaction to the 2022 mini-budget, analysts currently suggest such a scenario is unlikely, minimising the downside risk to GBP.

Dollar trims gains despite PMI outperformance

The upward bias on the US dollar arises from the strong performance of the US economy and increasing speculation of a Republican electoral victory, both of which have driven US yields higher across the curve as markets price out Federal Reserve interest-rate cuts. Both presidential candidates are also anticipated to increase the fiscal deficit, setting the US dollar on course for its largest monthly gain in two years. However, with the dollar index in overbought territory, it was unsurprising to see a lull in demand on Thursday, partially due to mixed US economic data.

Unemployment claims were lower than expected, yet continuing claims rose to their highest level since 2021. Regional Federal Reserve activity surveys showed weakness, contrasting with solid PMI figures from the US. The S&P PMI survey outperformed expectations for manufacturing, services, and composite measures, deepening the divide between the US and Europe. Meanwhile, US bond market volatility, as measured by the MOVE index, remains high, benefiting the US dollar, with which it holds a positive correlation. The MOVE index spiked recently as the US election enters its timeframe. Notably, on 7 October, the index experienced its largest single-day percentage surge since 2020, surpassing the Fed’s June 2022 rate hike announcement and the collapse of Silicon Valley Bank in March 2023.

What triggered the jump on 7 October without a clear catalyst? This was the first instance in which the new one-month option on the MOVE index expired after the election. This highlights market sentiment on the extreme risk of yield volatility post-election. In FX, we see similar moves, with EUR/USD hedging costs reaching a seven-year high over the next two weeks.

Pound gains on interest rate outlook

Thursday saw a volatile day for the pound, which was supported by rising 10-year UK gilt yields reaching a 16-week high. Reports indicate that UK finance minister Rachel Reeves may allow increased borrowing in the upcoming budget, potentially delaying Bank of England (BoE) rate cuts. GBP/USD rose through the day but struggled to break above $1.30.

The pound received further support from BoE rate-setter Catherine Mann, who warned that the UK may have eased interest rates too soon. However, weaker-than-forecast flash PMI numbers from the UK likely limited gains. Private sector growth slowed to an 11-month low, with the composite PMI falling to 51.7 in October from 52.6 in September. Services showed slightly stronger growth than manufacturing, but momentum weakened in both sectors. Overnight indexed swaps remain cautious, with market hesitation to price in two full rate cuts from the BoE for the rest of 2024. This has helped GBP/EUR retain its 4% gains year-to-date, supported by the dovish stance of the ECB and the UK-German two-year yield spread, now at its highest in over a year.

Adding to this, UK consumer confidence, as measured by the GfK Consumer Confidence Index, fell to its lowest point of the year. The lack of clarity around government tax plans likely contributes to muted consumer sentiment, despite improving economic indicators.

Gloomy outlook for the euro

The euro has become largely influenced by US developments, with little regard for European macroeconomic data. Global equities rebounded, and US Treasury yields declined in the previous session, allowing EUR/USD to return to the $1.08 range. Increasing options tenors now include US election risks, with the two-week implied-realized volatility spread on EUR/USD reaching its highest level since 2017. Relative hedging costs for the euro have also hit a seven-year peak, underscoring concerns over the European Union’s lack of a free trade agreement with the US.

Eurozone Governing Council members continue to resist aggressive policy easing, with Nagel and Makhlouf stating that 1) significant data would be required for large rate cuts, and 2) the ECB should not rush into easing. However, this position comes amid weak economic data. Europe’s two largest economies remain affected by high interest rates, declining external demand, and structural challenges. Germany’s manufacturing PMI has improved from a one-year low but is still in contraction. The uncertain business outlook continues to hinder investment, with France’s manufacturing outlook negative for 21 consecutive months and no signs of recovery. Business expectations are currently at their most pessimistic since May 2020.

Dollar Pauses Near 3-Month High

The Federal Reserve’s Beige Book once again depicts a sluggish US economy, seemingly at odds with the official data. However, this has had little impact on the markets. Instead, several bullish factors are driving the US dollar higher. There is a revival of the US exceptionalism narrative, and the rise in fixed-income volatility, with US yields hitting 3-month highs, is further supporting the dollar. Additionally, geopolitics and domestic politics are lending another layer of strength to the dollar, particularly as improved polling for Donald Trump ahead of the upcoming US election boosts confidence.

Beyond the resurgence of US economic exceptionalism, which is pushing the dollar and yields higher, market sentiment remains convinced that the Republicans are on course for an electoral win. Should this materialise, an increase in tariffs could strengthen the dollar by affecting risk sentiment and slowing trade. If higher tariffs also lead to greater inflation and influence the Federal Reserve’s policy stance, this would provide further support for the dollar through monetary policy channels. In the foreign exchange market, traders are preparing for such an outcome, with EUR/USD two-week implied volatility, which now captures the aftermath of the US election for the first time, recording its second-largest daily jump since the onset of the Covid-19 pandemic in 2020.

Elsewhere in North America, the Bank of Canada joined other central banks with a 50-basis point rate cut yesterday. The yield spread between US and Canadian two-year bonds is now at its widest since 1997, which may continue to put downward pressure on the Canadian dollar, also known as the "Loonie", a trend that could be exacerbated by a Republican victory in the coming weeks.

Sterling Slips Over 3% Month-to-Date

The British pound fell below its 100-day moving average yesterday, trading near $1.29, marking a decline of over 3% month-to-date against the US dollar. The ongoing strength of the dollar is driving the pair lower, and dovish comments from Bank of England Governor Andrew Bailey are further weighing on sterling as traders brace for the release of flash PMIs later this morning.

Bailey suggested that disinflation is occurring faster than expected, hinting that the central bank may continue lowering rates next month. Despite progress on inflation and a cooling in wage growth, traders remain cautious in betting that the BoE will cut rates in both November and December. Although rate expectations haven’t shifted significantly following Bailey’s remarks, and UK gilt yields continue to rise, sterling remains vulnerable to fluctuations in global risk sentiment, falling equities, and broad-based dollar strength as traders pare back expectations for Fed rate cuts and position themselves for what is likely to be a closely contested US election. The clear break below the 100-day moving average opens the door to the 200-week moving average at $1.2850 and the 200-day moving average, which is situated lower at $1.28.

Today’s focus will be on flash industry PMIs, which are expected to show continued expansion in the UK, with all readings anticipated to remain above 50. In September, employment, new orders, and future output expectations in the manufacturing sector fell, likely due to uncertainty surrounding the Budget. Meanwhile, the services sector has remained more resilient, experiencing over a year of expansion, driven by strong domestic demand. This highlights the contrasting performance between the UK and the Eurozone, where activity is contracting, helping the GBP/EUR rate stay around €1.20.

No Free Trade Agreement Spells Trouble for the Euro

The euro has faced numerous challenges over the past four weeks, including disappointing macroeconomic data from Germany, inflation below target in many Eurozone countries, and rising expectations of further monetary policy easing. Political uncertainty surrounding the US election has also weighed on the single currency.

However, deteriorating risk sentiment and falling stock markets have not been part of this narrative – until now. This week has seen a shift, with the S&P 500 on track to record its first weekly loss in eight weeks and volatility, both implied and realised, continuing to rise. This has pushed EUR/USD below $1.08, with $1.0750 now coming into focus.

The euro is not the only currency feeling the pressure of investors positioning themselves ahead of the US election. However, the absence of a free trade agreement (FTA) between the United States and the European Union suggests that economic pain may be on the horizon in the event of a Trump victory and an increase in tariffs. EUR/USD implied one-month volatility has now reached its highest level since early 2023, at 8.3%, and the premium on call options for the same period indicates that investors are more inclined to hedge against further downside risks rather than upside possibilities.