Dollar on the move

With no clear bearish drivers for the US dollar, its recent recovery from over a one-year low last month appears set to continue in the near term. The first phase of the dollar’s resurgence was driven by the strength of the US economy, but the second phase may be shaped by political factors. Both dynamics are pushing bond yields higher, not only in the US but across most major economies.

The resilience of the US economy goes beyond the impressive jobs report for September and the drop in the unemployment rate. Retail sales and the ISM services index also exceeded expectations. In addition, core inflation has gained momentum, signalling that inflation remains a persistent issue. Consequently, expectations for a quick reversal in Federal Reserve policy have been scaled back, fuelling a yield-driven rally in the dollar. Aside from the US’s economic strength, geopolitical and domestic political developments are providing further support for the dollar. Gold hit a record high on Monday, as tensions in the Middle East and a tightening US election race prompted a flight to safe-haven assets, including the US dollar.

The outcome of the US election is also crucial. Improved polling for Donald Trump could reinforce the upward momentum in bond yields and the dollar, given the potential implications for trade, fiscal, and monetary policies. With the election essentially a toss-up, it’s challenging for traders to predict the outcome, which may explain why EUR/USD and GBP/USD are struggling at the $1.08 and $1.30 levels, respectively. However, a Trump victory could knock as much as 5% off these exchange rates by the end of the year.

Pound hit by rising global yields

UK bond yields surged this morning across the yield curve, mirroring movements in major economies across the US, Europe, and Asia. Traders are trying to anticipate the future path of global interest rates, and with central banks in the G3 economies pricing in less easing over the next 24 months, the pound and other pro-cyclical currencies have faced renewed selling pressure against the US dollar. This trend has been evident since the interest rate hiking cycle ended in 2022.

The situation is largely driven by developments in the US. The resilience of the US economy has surprised market participants and central bank policymakers alike, prompting traders to scale back aggressive rate cut expectations. However, in the UK, signs of moderating inflation, a loosening labour market, and weakening economic momentum should, in theory, have increased the likelihood of rate cuts. A 25-basis-point cut is fully priced in for November, with a 70% chance of another in December, but the recent surge in bond yields suggests some uncertainty among bond traders about back-to-back cuts. Additionally, with the Bank of England no longer seen as an outlier in hawkishness, and overall G3 easing expectations being lowered, the pound has struggled against the dollar.

GBP/USD is hovering around $1.30 today, down nearly 3% for the month, though it remains almost 3% higher year-to-date. It still sits two cents above its five-year average of $1.28, which also aligns with its 200-day moving average – a level it often gravitates towards, as seen in August. Meanwhile, GBP/EUR remains above €1.20, close to a two-year high, buoyed by favourable growth and yield differentials for the pound.

Break of $1.08 in sight

The rise in US Treasury yields across the curve has dominated market discussions at the start of the week. The euro, like many other pro-risk currencies, has been unable to resist the downward pressure caused by widening rate differentials and is once again nearing the $1.08 mark. EUR/USD seems to be largely driven by developments in the US, where enthusiasm for Trump-related trade policies has resurged.

The negative economic news from Europe has done little to support the euro. Recent remarks from top European Central Bank members, such as François Villeroy de Galhau, suggesting that inflation will fall below 2% early next year, have paved the way for further policy easing. The ECB is expected to cut rates in December, followed by quarterly reductions throughout next year, which could see the deposit rate fall to between 1.75% and 2.0% by the end of 2025.

German producer inflation for September also came in lower than expected, with the PPI falling by 1.4%, compared to the anticipated decline of 0.8%. Christine Lagarde is scheduled to speak three times over the next two days, though it is unlikely her comments will shift market expectations regarding the ECB’s next policy move.

Pound Sterling Rebounds After Dropping Below $1.30 Amid BoE Rate Speculation

Last week, the pound fell below $1.30 at interbank (IB), marking its lowest level in over two months against the US dollar. This decline was driven primarily by the strength of the USD and increased speculation of potential Bank of England (BoE) rate cuts following UK wage and inflation data. However, the release of Friday's UK retail sales report provided some relief, pushing the GBP/USD exchange rate back above $1.30. Additionally, the GBP/EUR pair surged to new 2-year highs, climbing above €1.20 at IB, a level it has exceeded for only 3% of the post-Brexit period.

EUR/USD Recovers Slightly After ECB Rate Cut and US Election Concerns

The EUR/USD pair rebounded from a brief dip to $1.0810 at IB, closing the trading session around $1.0860 at IB. Despite this recovery, the euro remained lower over the week, pressured by the strength of the US dollar amid heightened election-related concerns. The European Central Bank (ECB) further weighed on the euro by cutting its deposit rate by 25 basis points to 3.25%, a move widely anticipated by the markets. ECB President Christine Lagarde’s cautious outlook on the European economy, citing weaker-than-expected growth, fuelled speculation that additional rate cuts may be necessary in the future.

Pound Sterling Uptrend Against Euro Expected to Continue, But Volatility Looms

The pound sterling is poised to extend its upward trend against the euro over the next five days. However, traders should be cautious of potential volatility driven by upcoming Bank of England speeches and the release of Thursday's PMI data.  BoE Governor Andrew Bailey is scheduled to speak this Tuesday, along with several other members of the Monetary Policy Committee (MPC).There is a risk that Bailey might interpret recent data as justification for accelerating the pace of interest rate cuts by the Bank.

Trump's Presidential Prospect Boosts Dollar Amid Election Volatility Concerns

The possibility of Donald Trump winning the presidential election is bolstering the US dollar, as his policies on tariffs, taxes, and immigration are viewed as inflationary, potentially leading the Federal Reserve to keep interest rates elevated for a longer period. A Republican clean sweep is seen as the greatest volatility risk, with traders increasingly positioning themselves for the election over the next two weeks.

Robust Spending and Strategic Rate Cuts

Throughout 2024, US exceptionalism has been a key theme, bolstering the dollar, bond yields, and equities. Yesterday, the dollar hit new 11-week highs, while stocks rose and bonds dipped, driven by a solid US retail sales report. Jobless claims also dropped by 19,000 to 241,000, reversing a spike from the previous week’s storm-related disruptions. In essence, the US economy is showing strength, making it likely that the Federal Reserve will proceed with cautious rate cuts.

In September, US retail sales grew by 0.4% month-on-month, far exceeding the 0.1% increase seen in August and beating market expectations of a 0.3% rise. This suggests another strong quarter of economic growth, underpinned by solid consumer demand, income growth, access to credit, and a resilient labour market. While the Fed is still expected to cut interest rates by 25 basis points next month, the robust retail figures add weight to the "no landing" thesis, signalling that consumer spending remains buoyant.

Looking ahead, the swaps market now reflects expectations of around 125 basis points of rate cuts through the seven scheduled Fed meetings up to July 2025, indicating the likelihood of two pauses during this period.

Pound Rallies on Strong Retail Sales

Retail sales in the UK unexpectedly rose by 0.3% month-on-month in September 2024, following a 1% increase in August, beating forecasts of a 0.3% decline. Sales at non-food stores surged by 2.5%, driven by strong demand for computers and telecommunications equipment. This positive data has given the pound a solid boost to close the week.

The British pound has climbed back towards $1.31 against the US dollar on the strength of these figures. The pound has also gained against the euro, reaching multi-month highs as the UK’s economic growth and yield differentials work in its favour. However, with several key risks on the horizon, the options market points to increasing downside risks for sterling. One-week and one-month risk reversals for GBP/USD are back in negative territory, indicating a growing preference for hedging against further declines in the pound or strength in the dollar.

Despite a slight retreat from its 2024 highs, one-month implied volatility for GBP/USD remains elevated at over 8%, which is two standard deviations above the year-to-date average of 6.6%.

Euro Weakens Amid Dovish ECB Stance

The euro has extended its three-week decline, weighed down by stronger-than-expected US data and a dovish European Central Bank (ECB) meeting. These developments reflect two major shifts that have turned against the euro. Earlier in the year, the rise of EUR/USD from $1.07 to $1.12 between May and September was based on expectations of a slowing US economy and a belief that the ECB would be less aggressive in cutting rates than the Federal Reserve. However, recent data suggests the US economy is gaining momentum, while economic disappointments in Europe are paving the way for further ECB easing, potentially as soon as December, which could lower the deposit rate to 3% by year-end.

Yesterday's 25 basis point cut was widely expected, with ECB President Christine Lagarde maintaining a data-driven, meeting-by-meeting approach. Yet, mounting downside risks to inflation have opened the door for further cuts. Markets now price in a 20% chance of a 50 basis point cut in December. However, a large cut seems unlikely for two reasons. First, the current easing cycle is already well underway, and a more aggressive move would signal that policymakers may have miscalculated previously. Second, while not stellar, recent economic data, including improved German sentiment and Eurozone industrial production, suggests some signs of recovery.

Looking ahead, the euro is expected to remain under pressure, particularly with the upcoming US election and the increasing likelihood of a Trump victory. The $1.0750 resistance level will be crucial to watch, though absent the political uncertainty, EUR/USD might have settled around $1.10. A win for Harris could push the euro higher, but for now, markets seem to favour Trump’s chances.

Trump trade rebounds

Despite a brief dip earlier this week due to easing tensions in the Middle East and a 5% drop in oil prices, the US dollar index has surged to a new 11-week high. Interestingly, 10-year US Treasury yields have declined, signalling that traders are seeking safety in bonds and the dollar ahead of several uncertain events on the horizon.

One of the key factors behind the dollar’s recent strength is the increasing likelihood of a Donald Trump victory in the US election, now just three weeks away. For the first time since Harris entered the race, Trump is leading in an average of the polls across seven swing states. Although the race remains incredibly tight, with just 0.34 percentage points separating the two candidates, the consistent shift in Trump's favour has caused concern among Democrats. Financial markets are also reacting. A Trump win is perceived as potentially inflationary, which could disrupt global trade and lessen the chances of further Federal Reserve rate cuts. This scenario points to higher yields, a stronger dollar (in the short term), and rising equities and cryptocurrencies.

Reflecting the uncertainty surrounding the election, the US equity volatility index (VIX) has remained above a key threshold for its longest streak in over two years. It is unusual for the VIX to stay above 20 when the S&P 500 closes at a new record high, as it has done recently. However, this extended period above that level often coincides with brief reversals in equity gains, which could negatively affect risk-sensitive currencies such as the AUD, NZD, NOK, and GBP. The US election typically impacts currencies most through risk and trade channels, meaning a Trump presidency would have a more pronounced market impact than a win for Harris, who is more focused on domestic issues.

Pound near two-month low

One-month implied volatility for GBP/USD remains close to its 2024 highs due to the upcoming US election and key central bank meetings. Seasonally, volatility tends to stay elevated towards the end of the year, especially in election years. However, it is not just the rising odds of a Trump victory and a stronger US dollar that are weighing on the pound. Expectations of a more dovish stance from the Bank of England (BoE) following weak UK economic data this week are also contributing to the pound's decline.

UK inflation fell to 1.7%, its lowest level in three years and 0.4 percentage points below the BoE's August forecast, driven by a notable reduction in services inflation, particularly airfares. Services inflation is now 0.6 percentage points below the BoE’s August projection. This reinforces the view that the BoE will implement two consecutive 25 basis point rate cuts from November onwards, in line with Governor Bailey’s recent statement that, if inflationary pressures continue to ease, the rate cuts could be more aggressive. This dovish shift is compounded by softening wage growth and expectations of slower GDP growth in the third quarter. These factors have pushed UK bond yields significantly lower, sending GBP/USD below the key psychological level of $1.30 for the first time since August.

The options market offers further insight into FX sentiment, with both 1-week and 1-month risk reversals for GBP/USD turning negative once again. This suggests a preference for hedging against further GBP weakness or USD strength. The next target is the 100-day moving average support level of $1.2954, followed by the 200-week moving average at $1.2844 and the 200-day moving average at $1.2794.

Euro slips as Trump gains momentum

The euro has declined in 14 of the past 16 trading sessions, with selling pressure building ahead of today’s highly anticipated European Central Bank (ECB) rate decision. Policymakers are widely expected to cut rates by another 25 basis points as part of their ongoing easing cycle.

A few weeks ago, markets were not anticipating rate changes. However, recent weak macroeconomic data and inflation consistently below target across much of Europe have prompted a more dovish stance from the ECB, with Governing Council members increasingly open to the idea of further cuts. The Federal Reserve, no longer expected to lead the easing cycle among developed economies, has also bolstered the outlook for the US dollar.

Adding to the euro’s struggles is the rise of Trump in betting markets and the growing likelihood of a Republican sweep. The euro’s downward momentum remains strong, but it appears to be nearing overstretched levels. A significant miss in US data may be needed to give the euro some respite.