Month-End Flows Pressure USD

The US dollar's weakness persisted on Wednesday, despite a lack of a clear catalyst. November month-end flows and reduced liquidity due to the Thanksgiving holiday may have amplified the dollar's softer performance. Simultaneously, US Treasury yields continued to trend lower, with the benchmark 10-year yield falling to 4.25%, the lower bound of a range established over the past three weeks.

On the economic data front, attention centred on the Federal Reserve’s (Fed) preferred inflation measure—the PCE index—which aligned closely with expectations on both headline and core readings. However, income growth significantly outpaced forecasts at 0.6% month-on-month, signalling that the factors underpinning robust consumer spending remain strong. Despite this, currency traders largely ignored the data, and the dollar index experienced its steepest daily decline since early August.

The foreign exchange (FX) market has been more volatile this week, partly influenced by news linked to President-elect Donald Trump, likely prompting some consolidation. With US markets closed on Thursday and Friday, any erratic movements in major currencies are likely to be considered as mere noise.

Euro Logs Best Day Since August

The euro recorded its most substantial daily gain against the US dollar since August, buoyed by broad-based dollar weakness and shifting policy expectations. Renewed focus on France’s fiscal challenges highlighted a European narrative of subdued growth and rising yields, which could weigh on the euro. However, the French 10-year yield premium eased from a 12-year high as German yields rose in response to hawkish comments from European Central Bank (ECB) board member Isabel Schnabel.

Earlier on Wednesday, the spread between French and German 10-year bond yields widened to its largest margin since the euro-area debt crisis in 2012. Market jitters were triggered by reports that President Emmanuel Macron indicated Prime Minister Michel Barnier might face a no-confidence vote, while Barnier warned of potential financial market turbulence if his budget proposals were rejected.

Nonetheless, the euro was unaffected by these developments, instead benefitting from traders scaling back expectations of further ECB rate cuts following Schnabel's assertion that the room for additional monetary easing is limited. Holding above the $1.05 mark bodes well for the euro in the short term. However, looking ahead to 2025, we maintain the view that parity trading remains a significant risk due to rate and growth differentials and the potential for renewed trade tariff disputes.

Pound Rebounds from Oversold Levels

The week has been volatile for sterling, driven primarily by external factors as global developments have created a seesaw effect between risk-on and risk-off market conditions. At present, risk appetite appears to be on the rise, bolstering higher-risk assets, including equities, cryptocurrencies, and high-beta currencies like the pound.

GBP/USD has staged an impressive recovery from its six-month low, climbing into the upper range of $1.26 and moving out of oversold territory, as suggested by the 14-day relative strength index. Interest rate differentials support a fair value estimate of $1.29 for GBP/USD, but uncertainties surrounding global trade tensions could easily push sterling lower should fresh tariff concerns dampen market sentiment. In the near term, weak seasonal trends for the dollar and month-end flows favouring USD selling could see GBP/USD edge closer to its 50-week and 200-day moving averages, around $1.28.

Against the euro, sterling remains tethered near the €1.20 level, fluctuating within a narrow 1.3% range for most of the month. Excluding the fallout from the UK’s mini-budget in 2022, the UK-German two-year yield spread is near its highest point since 2005. This adds to the upside potential for GBP/EUR as money markets anticipate the ECB cutting rates nearly twice as much as the Bank of England by the end of next year.

Wild Swings: A Glimpse of What Lies Ahead

This week in the foreign exchange (FX) market has already been a turbulent one, influenced by international developments, particularly in the United States. The market sentiment initially improved following the nomination of Scott Bessent as Treasury Secretary, prompting traders to unwind their “Trump trades.” However, the “Trump trade” was reignited when the president-elect renewed his threats of tariffs. While the overbought US dollar has paused for breath, its counterparts have experienced significant volatility.

The imposition of an additional 10% levy on goods from China and a 25% tariff on all products from Mexico and Canada caught markets off guard. The Canadian dollar (CAD), in particular, dropped to a fresh four-year low against the US dollar. Hedging costs for CAD soared to their highest level in over two years, while one-month risk-reversal options—a metric indicating the cost of purchasing versus selling a currency and a gauge of market sentiment—are now at their most bearish for CAD in two years. According to Barclay’s import substitution model, a 25% tariff on all imports from Canada could cause a 19% depreciation of CAD against USD. While this threat may be exaggerated, the sharp movements in FX markets following Trump’s announcements underscore the extent of volatility his comments can provoke, as well as their widespread effects.

On the economic front, the US Conference Board’s consumer confidence index aligned with expectations, rising to 111.7—its highest level since July of last year. The likelihood of a Federal Reserve rate cut next month remains uncertain, and investors are expected to maintain interest rates within a range until clearer indications emerge from October’s core PCE deflator, which will reveal whether disinflationary progress is continuing or has stalled. This data is due later today.

The Allure of the Yen

The Japanese yen is in high demand today, despite improved investor sentiment following a ceasefire agreement between Israel and Hezbollah. This suggests that FX traders are positioning for a potential interest rate hike from the Bank of Japan (BoJ) next month.

The yen has strengthened nearly 2% against the US dollar this week, while also appreciating by around 1% against the euro, Australian dollar, and pound sterling. In fact, the yen has risen against 86% of the global currencies tracked this month. The last time the yen experienced such broad-based strength was during the summer when carry trades were being swiftly unwound.

Rates traders now price a greater than 65% probability of a BoJ rate hike in three weeks. Investors are closely monitoring Tokyo’s inflation data, due later this week, which could provide further insights into the BoJ’s monetary policy trajectory.

A Not-So-Sterling Fourth Quarter for the Pound

Even before the US election, the pound’s upward momentum had begun to wane. GBP/USD has fallen by over 5% quarter-to-date—a stark contrast to its historical average gain of 1% in the fourth quarter since 1971. The pair has breached key moving average support levels, trading near oversold territory on both daily and weekly charts.

In addition to external pressures, the UK economy is faltering, and its debt dynamics are once again drawing scrutiny. Following last week’s disappointing retail sales and PMI data, further deterioration in UK economic indicators could lead to broad-based sterling weakness. This year’s rally in the pound had largely been underpinned by an improving UK economic cycle, which lent sterling an advantage through its relatively high interest rates compared to other currencies.

Although UK rates remain elevated and are expected to stay so until 2025, international developments—especially the geopolitical fallout and the influence of the US election—are amplifying sterling’s downward momentum via the strong US dollar channel.

The incoming Republican administration is likely to prioritise countries with substantial trade surpluses with the US, imposing significant tariffs on imports. The UK, with its smaller trade surplus, is likely to be lower on Trump’s agenda. Nonetheless, the positive dollar environment could persist into next year, with GBP/USD potentially falling below $1.25 if EUR/USD approaches parity.

CAD Plunges Following Trump’s Tariff Threat

President-elect Donald Trump has announced plans to impose a 25% tariff on all US imports from Canada and Mexico, along with an additional 10% levy targeted at China. These announcements, signalling the start of Trump’s combative trade agenda, have unsettled FX markets. The Canadian dollar (CAD) weakened by as much as 1.5% within two hours of the remarks, offering a glimpse of the volatility that could define a second Trump presidency.

The initial reaction in the dollar-yuan pairing has been muted; however, the Mexican peso mirrored CAD’s performance, shedding 1.5% so far today. USD/CAD has surged to its highest level in over four years, and the escalation of tariff tensions suggests further gains towards C$1.45 are plausible. Both the pound and euro are benefiting from the weaker Canadian dollar, rising about 0.7% this morning, with GBP finding solid support at its 200-day moving average.

While the full scope of potential retaliatory measures from affected countries remains uncertain, the likelihood of fresh headlines keeps volatility risks elevated. Today’s market reaction to Trump’s comments, combined with the experience of his first term, indicates FX traders are bracing for a turbulent four years. Although options markets trimmed bets on a stronger US dollar following the announcement of Scott Bessent as Treasury Secretary, the tariff headlines have reignited dollar strength across the board.

A Temporary Boost for the Euro

Europe’s economic struggles were underscored this week by Germany’s Ifo index, a key leading indicator, which saw another decline. Despite this, EUR/USD managed a modest recovery from Friday’s dip to $1.0335, hovering just below $1.05. However, concerns over stagflation in Europe suggest that further declines in EUR/USD are likely as the year progresses, even as seasonal trends typically offer support.

After showing a brief recovery in October, the Ifo index fell again in November, declining to 85.7 from 86.5. The drop was driven more by current conditions than future expectations, with weak industrial orders and negative headlines surrounding the war in Ukraine weighing on sentiment. With no substantial tailwinds in sight, parity between the euro and the dollar appears increasingly probable within the next year. Bloomberg data now places the options-implied probability of parity trading within the next six months at 30%, up from 20% at the start of November.

Net short positions in the euro against the dollar have increased, according to COT data, but remain below levels seen during past crises, suggesting room for further downside risks. If Europe’s economic challenges persist, the euro could face its worst two-month stretch since January 2015.

The Pound Struggles for Momentum

GBP/USD is finding it difficult to reclaim the $1.26 level and its 100-week moving average, despite the US dollar beginning the week on a softer note. The yield spread between the UK and US remains relatively stable, with falling yields in both markets. However, the pound has failed to capitalise on improving global sentiment, as evidenced by Monday’s rally in global equities.

The pound also slipped below €1.20 against the euro, losing approximately 0.5% on Monday—its worst single-day performance this month. Money markets are pricing less than a 20% chance of a Bank of England (BoE) rate cut in December, with three cuts fully expected by the end of 2025. While recent inflation increases and fiscal expansion suggest a slower pace of BoE rate cuts initially, rising stagflation concerns are limiting sterling’s potential gains from this outlook.

Looking ahead, the UK’s trade deficit in goods with the US likely reduces its direct exposure to Trump’s proposed tariffs. This supports the case for UK economic outperformance relative to the Eurozone, potentially keeping GBP/EUR on an upward trajectory.

Against the US dollar, however, the picture remains less optimistic. Even with weak seasonal trends for the dollar and month-end flows favouring USD selling this week, GBP/USD remains in a downtrend as long as it trades below $1.28 and its key 200-day and 200-week moving averages, which are clustered around this level.

The United Kingdom's economy is edging closer to recession following the government's controversial budget, which has been criticised for being unfriendly to businesses. Sterling initially gained against the Euro as data revealed a sharp slowdown in the Eurozone economy during November. However, this optimism was short-lived as the UK’s own economic challenges were brought into focus. A Purchasing Managers’ Index (PMI) survey highlighted worsening business sentiment, largely attributed to the government's October fiscal policies. According to S&P Global, the UK composite PMI dropped to 49.9 in November from 51.8, reflecting contractionary pressures that underscore mounting economic challenges.

The UK's manufacturing sector has officially entered contraction, with the PMI falling to 48.6, down from 49.9 in the previous month, in line with global manufacturing headwinds. Alarmingly, the services sector, which forms the backbone of the UK economy, is now teetering on the brink, with a PMI reading of 50, a critical threshold, down from 52. The deterioration in sentiment and output across key sectors highlights a significant slowdown in economic activity. Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, noted the concerning outlook, stating that falling output and consecutive monthly job cuts point to a deepening malaise in the post-Budget economy.

The report also underlined the growing inflationary pressures facing businesses, with November witnessing a sharp rise in input costs, particularly in the service sector. This presents a difficult scenario for the Bank of England. While a weakening labour market might typically prompt rate cuts, rising inflation ties its hands. Currency markets reflected these challenges, with GBP/EUR briefly surging to 1.2094 before falling back to 1.2034, while GBP/USD continued its decline, hitting 1.2523 amidst robust U.S. economic performance. Investors have adjusted their expectations for UK interest rate cuts, now anticipating three reductions next year, with a February cut fully priced in. In contrast to the UK’s struggles, the U.S. economy continues to expand, leaving the Pound under sustained pressure against the Dollar. Meanwhile, lingering uncertainties in the Eurozone could provide limited support for the Pound against the Euro.