Euro Slides to $1.05 Amid Rising Risks and Market Uncertainty

The euro has sharply declined to $1.05 against the US dollar at inter-bank (IB), losing nearly 1% due to escalating geopolitical tensions, trade risks, and widening interest rate differentials that weigh against the euro. This drop comes despite a significant surge in Eurozone wages, which complicates the European Central Bank's (ECB) plans to ease monetary policy as inflation slows.

Eurozone third-quarter negotiated pay increased by 5.4% year-on-year, up from 3.5% in the prior quarter, with Germany driving much of the growth. While wage growth signals persistent inflationary pressures—a key focus for the ECB—a weakened economic outlook and reduced corporate pricing power are likely to keep the easing cycle on track. Investors are pricing in a 139-basis-point rate cut by the ECB by the end of 2025, but ECB officials have downplayed the likelihood of aggressive monetary easing, pointing to increased volatility in euro interest rates heading into 2024.

In the foreign exchange (FX) options market, traders are increasingly positioning for a weaker euro as the currency hovers near its 2024 low. A sustained breach below the $1.05 mark at IB could pave the way for a decline to $1.03 at IB, a key downside target, particularly under the scenario of a "Red Sweep" in US elections. Geopolitical factors, such as a potential escalation in the Russia-Ukraine conflict, could add further downward pressure to the euro, exacerbating its vulnerabilities in the global economic landscape.

Sterling Slumps Against the Dollar but Holds Gains Versus the Euro

The British pound has erased all its post-inflation gains against the US dollar, sliding into negative territory for the year and dropping over 2% month-to-date. Currently trading about two cents below its five-year average, GBP/USD has fallen significantly from being six cents above this level less than two months ago—a shift attributed to the "Trump effect." In contrast, GBP/EUR has reclaimed the €1.20 mark at IB, rising over 4% year-to-date and sitting five cents above its five-year average.

The bullish outlook for sterling, driven by cyclical factors since early 2024, may persist into 2025 if UK economic data remains strong and inflation continues to outpace expectations. This scenario could prompt the Bank of England (BoE) to delay rate cuts. However, uncertainty looms as the October UK Budget introduces a new fiscal-monetary policy mix. While initially supportive for the pound, concerns are growing over the potential for tax hikes to dampen consumption and economic growth. If UK economic performance falters, sterling could face renewed pressure. Flash industry PMIs, due tomorrow, will provide further insight into the economy's health as 2024 draws to a close.

For the BoE, no rate changes are expected in December, with the central bank likely to maintain its gradual pace of rate cuts, interpreted as one reduction per quarter. With markets currently pricing in only 60 basis points of cuts by the end of 2025, there is room for traders to adjust their expectations, potentially leading to further downward corrections for sterling.

Dollar Strengthens Amid US Exceptionalism Narrative but Faces December Headwinds

Russia’s revision of its nuclear doctrine initially triggered a surge in safe-haven demand, but investor focus quickly shifted back to the US economy. Recent better-than-expected economic data, combined with a Republican sweep of the presidential and congressional elections, have bolstered the narrative of US exceptionalism. This economic resilience and upward revisions to GDP forecasts contributed to significant dollar gains in 2024, a trend that may continue into early 2025.

Despite the dollar’s momentum, uncertainties remain. Key questions include the timing and impact of fiscal and tariff policy changes, how global peers might respond, and whether upcoming US data will continue to confirm economic outperformance. Additionally, December’s historically weak seasonality for the dollar could present a window for other currencies to recover some lost ground.

Sterling Surges Amid Strong UK Inflation Data  

Sterling climbed above $1.27 at inter-bank (IB) against the US dollar and €1.20 at IB against the euro this morning, buoyed by unexpectedly high UK inflation figures. The data adds pressure on the Bank of England (BoE) to postpone further interest rate cuts until next year, enhancing the pound's yield appeal.  

Annual headline CPI increased to 2.3% in October, surpassing the forecast of 2.2% and up from 1.7% in September. The rise was driven largely by higher housing and household services costs, particularly electricity and gas prices, following the 10% hike in the UK energy price cap for October. This marked the largest monthly inflation jump since October 2022. Core inflation also exceeded expectations at 3.3%, while services inflation edged back to 5%, consistent with BoE forecasts.  

Despite cutting interest rates twice to 4.75%, the BoE is now expected to delay further reductions. A 25-basis-point cut initially anticipated in December is now projected for February, with markets pricing the next full cut for March. Investor expectations for cumulative easing through 2025 have been reduced, with 59 basis points now priced in, down from nearly 67 yesterday.  

While stretched speculative bullish positions may pose downside risks to sterling, today's inflation report could fuel further short-term gains for the pound.

Geopolitical Tensions Spark Shift to Safe Havens  

Renewed tensions between Russia and the US triggered volatility across financial markets yesterday, driving investors toward safe-haven assets. Treasury bonds, gold, the US dollar, Swiss franc, and Japanese yen all gained, while the Polish zloty suffered the steepest losses due to its geographical proximity to the conflict.  

The resurgence of geopolitical risks followed updates to Russia’s nuclear doctrine and reports of a Ukrainian missile strike within Russian territory. Russia has warned that Ukraine's use of Western-supplied non-nuclear missiles against Russian targets could provoke a nuclear response, heightening fears of escalation.

Limited Upside for EUR/USD Amid Persistent Headwinds  

Despite a brief reprieve from selling pressure, the euro lacks a strong foundation for a significant recovery against the US dollar. Weak economic conditions in the Eurozone, political uncertainties, trade tariff risks, and widening interest rate differentials continue to weigh on the currency, suggesting sustained weakness in the medium term.  

Since Trump’s re-election, EUR/USD has declined over 3%, and the drop extends to over 6% since the end of September. The $1.05 level remains a critical psychological support, but further downside appears likely without clear policy actions from the new administration. Trade tariffs pose a significant risk for EUR/USD volatility, while widening rate divergence is expected to sustain downward pressure on the pair.  

Although potential stimulus measures from China could lend support to the euro, current policy announcements have underwhelmed, leaving little room for optimism about a reversal in EUR/USD's downward trend.

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.