Monfor Weekly Update

A busy week lies ahead, filled with significant data releases, events, and Q3 US earnings reports, all with the potential to move markets.

The ECB is expected to keep interest rates unchanged at Thursday’s meeting but will likely provide further guidance suggesting rate cuts at the September 12 meeting. Financial markets are currently pricing in an additional 45 basis points of rate cuts for 2024.

Next week's economic calendar is dominated by inflation reports from Canada, the UK, the Euro Area, and Japan. Additionally, China's Q2 GDP, UK employment data, and German and Euro Area ZEW sentiment readings will be released. These data points will be spread throughout the week, adding volatility to various FX pairs. If this week’s inflation and wage figures are supportive, we forecast GBP/EUR to reach a target of 1.1985 in the coming days. However, if the data falls short, a decline to our downside target of 1.1768 is possible. Friday’s Retail Sales report is also crucial, with forecasts for June at approximately -0.6%, compared to a solid 2.9% previously. Any positive reading is likely to support Sterling.

Pound Sterling’s strong performance has placed it at the top of the G10 currency basket for 2024, though challenges remain. An overbought Pound will be increasingly vulnerable to disappointing data releases (excluding England’s disappointing performance against Spain!).

Across the pond, The week has begun with a stronger US dollar, driven by the renewed "Trump trade" following Saturday's assassination attempt on the former president. This development increases the likelihood of a Trump victory, and his proposed tax cuts and trade tariffs, which are viewed as inflationary, may compel the Federal Reserve (Fed) to maintain high US interest rates for a longer period.

Convincing Fall in U.S. Inflation

The two-year Treasury yield dropped more than 12 basis points, falling from 4.62% to 4.50%, and the US dollar index hit a five-week low after the US CPI report revealed inflation slowed more than expected last month. Earlier in the week, Fed Chair Jerome Powell indicated that the central bank needed more confidence in the inflation slowdown before adjusting rates. This CPI report may provide that reassurance. Softer economic data in recent weeks have further fuelled concerns about a sudden US slowdown. Consequently, traders now anticipate up to 60 basis points of rate cuts this year, suggesting two definite cuts and a potential third. The dollar is naturally under pressure, with the 104 level on the DXY being a key support focus. If the US 2-year yield remains at 4.5%, it could limit further losses, but the bond market's expectation of more cuts extending into 2025 may keep the dollar under pressure.

In a surprising turn for many investors, major US equity indices saw a sharp decline, with the Nasdaq dropping 2%, marking its weakest day since mid-April. This is the worst reaction to an inflation disappointment since the Fed began raising rates in early 2022. One interpretation is that the market had already priced in much of the anticipated good news regarding Fed rate cuts. Alternatively, the market may not have adequately discounted easier policy, and the inflation report now provides the Fed with a mandate to cut rates. This shift has moved capital from the overbought tech sector into value and small-cap stocks, resulting in the Russell 2000 having its best week of the year so far.

The specific reason for the capital reallocation is less critical to our macro thesis and the declining US dollar. Inflation declined on a monthly basis for the first time since the pandemic. Persistent indicators like core, shelter, and services inflation continued to ease in June as the headline figure fell to 3.0%. Heading into the last day of the week, attention will turn to the producer price index, which is expected to increase from 2.2% to 2.3% in June. This aligns with our assumption of continued disinflation in the consumer sector while reflation in the industrial sector begins to build. This could pose a problem for the Fed in the future. For now, the market welcomes the news of lower inflation.

Sterling surged over a cent against the US dollar to $1.2949 yesterday, marking its highest level since July 2023 and surpassing its key 200-week moving average of $1.2850. If it closes the week above this level, it could trigger further gains. This climb was fuelled by hawkish comments from Bank of England (BoE) policymakers, stronger UK GDP data, and a softer US inflation report.

The pound has outperformed all its major peers this year due to expectations that the BoE will need to maintain interest rates at 16-year highs for an extended period, driven by a surprisingly robust economic recovery and persistent concerns about stubborn services inflation and wage pressures. The UK economy grew by 0.4% in May, double the expected rate, positioning Britain for another solid quarter of expansion after leading the G7 in GDP growth in Q1. While some central banks are already cutting rates, the BoE has suggested that an August rate cut may be unlikely as inflation is expected to rise again. Money markets currently predict about a 50% chance of a cut in August and 49 basis points of easing by the end of the year.

This outlook bodes well for the pound, which is also buoyed by optimism that the newly-elected Labour government will bring political stability and a prudent approach to national finances. Adding to the pound’s recent strength was data showing that US inflation cooled last month, increasing expectations of more Fed rate cuts this year and next.

 

UK economy grows faster than expected

The Pound Sterling surged after the UK's GDP growth exceeded expectations in May, reducing the likelihood of an interest rate cut on August 1. The Pound to Euro exchange rate climbed to a one-month high, while the Pound to Dollar exchange rate reached a four-month high following the ONS report that UK GDP rose 0.4% month-on-month in May.

This increase more than doubled the consensus estimate of 0.2% growth and surpassed April's stagnant 0% reading. The growth was primarily driven by the services sector, the largest in the UK economy, which saw output increase by 0.3% in May 2024.

As a result, the UK economy grew by 0.9% in the three months to May 2024 compared to the previous three months, with services output rising by 1.1%. These figures indicate a robust ongoing economic recovery in the UK, reducing the need for the Bank of England to intervene with an interest rate cut.

May marked the fourth increase in GDP over the past five months. Ashley Webb, UK Economist at Capital Economics, notes that this trend supports the idea that the negative impacts of higher interest rates and inflation are beginning to diminish. Capital Economics now projects that GDP for the second quarter is on track for a 0.7% quarterly increase, matching the first quarter's growth.

As of 8am today, GBP/USD rallied to 1.2863, and GBP/EUR reached 1.1867.

Powell strikes balanced tone

The US dollar continued its rebound from three-week lows as investors processed the less dovish comments from Federal Reserve Chair Jerome Powell’s testimony before Congress. The GBP/USD pair fell back below $1.28, while EUR/USD hovered around $1.08. The most significant gains were against the Japanese yen, with USD/JPY nearing fresh 38-year highs.

Powell emphasized that the Fed would not consider reducing interest rates until there is confidence that inflation is moving sustainably toward 2%, indicating that first-quarter data did not provide such assurance. Following his comments, US Treasury yields rose, with the 10-year note climbing back above 4.3%. Despite this, the S&P 500 and the Nasdaq remained at record levels on Tuesday, with the former not experiencing a 2% drop in 345 days, the longest streak since 2017-2018. Despite Powell's less dovish tone, equity markets remain optimistic about the prospect of future rate cuts, although the data must support such a move. Powell noted that while the US labour market is more balanced, the Fed is concerned about the rising unemployment rate, which could prompt earlier rate cuts.

Inflation remains the key uncertainty. We anticipate that easing price pressures will give the Fed enough confidence to begin cutting rates in September, potentially lowering US yields and the dollar. However, markets could react negatively if the upcoming inflation report on Thursday exceeds expectations.

The European calendar lacks significant domestic data releases today. ECB’s Nagel is set to speak this morning, but this is not expected to be a market-moving event. Attention shifts back to the US, where round two of Powell’s testimony before the House Financial Services Committee is unlikely to bring surprises, as the Chairman is expected to reiterate his previous remarks. Consequently, FX volatility is expected to diminish further as markets adopt a wait-and-see approach ahead of the US CPI release tomorrow.

The pound continues to struggle to surpass its 200-week moving average against the US dollar, a resistance level that has held firm for a year. However, if the narrative of US economic exceptionalism continues to moderate and the UK’s economic recovery accelerates—driven by a significant drop in inflation and lower interest rates boosting real household incomes—we believe the pro-cyclical pound could trend higher by year-end.

Euro shrugs off French election woes

The EUR/USD remained steady at $1.084 after briefly falling to $1.08 as investors moved past the initial shock of France's election results. A leftist alliance unexpectedly took the lead, resulting in a hung parliament. Despite initial resilience, the French CAC 40 closed in the red, mirroring the performance of global equities, as France now faces challenging negotiations and uncertainty in forming a government. The OAT-Bund 10-year spread narrowed to 62bps, a fresh 3-week low, as this outcome is seen as more favorable compared to a potential right-wing government.

In economic data, Germany's trade surplus in May rose to €24.9 billion, a 4-month high, despite decreased demand for both imports and exports. Exports fell 3.6% month-on-month to a five-month low, while imports declined by 6.6% month-on-month, also reaching a five-month low. Additionally, ECB’s Knot joined other Governing Council members in endorsing current market expectations for rates in 2024 (40-42bps). With ECB rate cut expectations likely stable in the coming weeks and potential additional easing anticipated for September 2024, the Fed's actions will be a major driver for EUR/USD. Attention now shifts to the US CPI report due on Thursday.

The Euro index, which tracks the performance of the euro against a basket of nine leading global currencies, ended the day slightly lower due to a cautious market mood. EUR/GBP declined for the second consecutive day as political tensions weighed on the euro. Despite the ongoing turmoil in France, further advances may be limited as the pair approaches its 200-month SMA at €1.1870, a key moving average it has struggled to break since Brexit.

Please note:  The news and information contained on this site should not be interpreted as advice or as a solicitation to offer to convert any currency or as a recommendation to trade.

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