Positive Economic Data Fuels Risk Sentiment as Focus Shifts to Fed's Rate-Cutting Prospects

US inflation continues to ease, initial jobless claims were lower than expected, retail sales in July saw their best performance of the year so far, and consumer confidence rose for the first time in five months. These positive developments contributed to upbeat risk sentiment last week. Investors focused on the disinflation narrative and a risk-on rally, leading to a sell-off in the dollar, despite lower recession probabilities that would typically support the Greenback.

This reaction can be understood through the perspective of Fed funds futures. Stronger macroeconomic data have increased the likelihood of a 25 basis point rate cut in September (rather than 50 basis points), with around 175 basis points of cuts priced in over the next 12 months. This significant expectation of easier monetary policy has weighed on the dollar.

Jerome Powell’s upcoming speech at the Jackson Hole Symposium later this week is expected to shed more light on the Federal Reserve’s response to recent economic data. Options markets are currently predicting a swing of over 1% in the US equity benchmark (S&P 500) on Friday, driven by Powell’s address. The focus has shifted from whether the Fed will cut rates in September to the extent of the cuts. For risk assets to continue their upward trend, Powell will need to reinforce this message. Investors are optimistic about imminent rate cuts and are betting on reduced volatility, with the central bank’s data dependency highlighting the importance of upcoming macroeconomic data.

British Pound Recovers as GBP/USD Surges Amid Easing US Inflation and Strong UK Economic Data

GBP recovered its losses from the previous three weeks in just one week, with GBP/USD rising by 1.4%. This was the currency pair's fourth-best performance of the year, driven by easing inflation in the United States and the UK economy surpassing expectations.

US bond yields are falling more swiftly, shifting the rate differential in favour of the pound. For the first time since last September, investors are now receiving a higher yield from British 10-year government bonds compared to US Treasuries. This shift has helped GBP/USD climb back to the high $1.29 level, with $1.30 now clearly in sight.

From a macroeconomic standpoint, August has effectively concluded for the UK, with all pertinent data released last week. Retail sales, GDP, and labour market figures all surpassed expectations, while inflation increased more gradually than anticipated. This news will be welcomed by the Bank of England, which is striving for a smooth economic transition and now faces uncertainty over its next rate decision. The positive developments are likely to bolster the pound for a period, but the direction of the currency pair will ultimately hinge on upcoming US economic data.

Euro Gains from Risk-On Sentiment as Focus Shifts to US Economic Data and Fed Expectations

The euro has recently gained from a renewed risk-on sentiment, despite investors recalibrating their expectations for substantial Federal Reserve easing in 2024. Positive economic data from the US have alleviated fears of a sharp economic downturn. This, combined with the renewed risk-on sentiment and enhanced market stability, has propelled EUR/USD close to its 2024 peaks.

Domestically, growth remains largely supported by the services sector, while manufacturing continues to struggle, with industrial production falling sharply. Recent indicators, such as Germany’s ZEW survey, have worsened, reflecting growing uncertainty and concerns about global events. Despite these challenges, investors are currently more focused on US developments and the Federal Reserve’s outlook.

This week’s negotiated wages data could shift attention back to the European Central Bank (ECB), as this metric is crucial for the Governing Council when considering future rate cuts. Recent data from Italy have shown persistent upward wage pressures, and if this trend is reflected in broader Eurozone figures, it could challenge expectations of an ECB rate cut in September, potentially boosting the euro. Flash August PMIs, due later this week, will also be important for assessing growth momentum. Any further signs of deterioration could diminish some of the euro’s recent gains.

US Soft Landing Remains Intact, Boosting Equities and Investor Confidence

Stronger retail sales and lower-than-expected jobless claims numbers suggest that the US soft landing remains intact, serving as a positive catalyst for equities and broader investor sentiment. This renewed risk-on sentiment has driven US yields higher, as expectations of rate cuts by the Federal Reserve (Fed) have been scaled back, lending support to the US dollar.

Overall, the current dynamic indicates that the Fed is more likely to deliver a 25-basis point cut, rather than a 50-basis point cut, when it begins easing, likely in September. While the prospect of fewer rate cuts had previously weighed on stocks, this time it is being driven by the idea that recession risks may have been overstated. The labour market is cooling gradually, defying expectations of a sharper slowdown, with initial jobless claims coming in lower than anticipated at 227,000. Meanwhile, consumer spending continues to reinforce the narrative of US exceptionalism, with retail sales exceeding expectations by posting a 1% gain in July, the strongest reading since January 2023. Following declines seen after this week’s lower Producer Price Index (PPI) and cooler Consumer Price Index (CPI) data, two-year yields have surged back above 4%, as the data not only dispelled growth concerns but also reignited inflation worries, with import prices rising more than forecast.

Swaps tied to the Fed’s September meeting show traders trimming their bets on a cut, with approximately 31 basis points priced in. They are also now pricing in less than 100 basis points of Fed cuts in 2024. The upcoming Jackson Hole Economic Policy Symposium next week is expected to provide further insights into the economic and monetary outlook, which will continue to guide market trends.

Sterling Adjusts Lower Against Euro Amid Rate Differentials and Softer UK Inflation

Rate differentials had suggested that sterling was overvalued against the euro, leading to a correction in the GBP/EUR exchange rate to a more balanced level around €1.16-€1.17, down from over two-year highs above €1.19. This adjustment has resulted in the pair declining for five consecutive weeks, marking its worst performance since Q3 2022. Contributing to the decline was a softer-than-expected UK services inflation reading, which boosted expectations of Bank of England (BoE) easing and dragged the UK-German 2-year yield spread to its lowest level in over a year.

However, the 200-week moving average appears to be a strong support at €1.1609. While the 200-day moving average had been a tough short-term resistance at €1.1692, the pair reclaimed €1.17 yesterday as EUR/USD dropped back below $1.10. Despite sterling’s difficulties in August, the 1-year UK-US rate differential suggests that GBP/USD’s approximate 3% drop since mid-July may have been overdone. Indeed, the downward momentum slowed near the 100- and 200-day moving averages, allowing the pair to break a four-week losing streak and rebound over 1.5% from last week’s lows, moving back above its five-year average of $1.28. The pair is now testing the 200-week moving average resistance, and a decisive close above it could support further gains in the short term. Stable equity markets and a sustained global easing bias are likely to remain supportive of the pro-cyclical currency, particularly against its safe-haven peers. However, sterling will need a new positive catalyst to bolster its upward trajectory from the first half of 2024.

On the macroeconomic front, July retail sales rose by 0.5% month-on-month, in line with market expectations. Sales at non-food stores increased by 1.4%, particularly in department stores and sports equipment stores, driven by summer discounting and sporting events. Excluding fuel, retail sales rose by 0.7%, stronger than the 0.6% rate economists had expected. The proportion of sales made online also edged up to 27.8% from 27.4% the previous month.

European Stocks Rally as US Economic Data Eases Concerns

European stocks rallied and bonds sold off as encouraging data from the US alleviated investors’ worries about a rapidly deteriorating US economic outlook. The STOXX 50 index is up nearly 1.6% week-to-date, having recovered close to 90% of the losses incurred in August. Meanwhile, the two-year German bond yield rose to a two-week high of 2.45%, following the upward movement in US Treasury yields. The front-end spread widened to 165 basis points but remains structurally narrower compared to levels seen before the non-farm payroll (NFP) reports at the end of July. Nevertheless, the move pushed EUR/USD to a session low of $1.095 before the pair recouped some of its losses.

No macroeconomic reports were released today in the Eurozone, but there was still plenty of market interest as the Norges Bank held its monetary policy meeting. The committee decided to keep its key policy rate steady at a sixteen-year high of 4.5% for the fifth consecutive meeting. The Bank warned that the interest rate would likely remain at the current level for some time, as policymakers are concerned about a weaker krone and its potential implications for inflation. However, there are also worries that overly tight monetary policy could restrain the economy more than necessary, as signs of slowing are already apparent, with unemployment edging higher. Given the largely unsurprising outcome of the meeting, EUR/NOK closed only 0.05% lower on the day.

The prospect of the US economy and interest rates converging toward lower levels, similar to those in the rest of the world, along with a renewed risk-on sentiment, is proving supportive for EUR/USD. The pair continues to be driven almost entirely by US macroeconomic data and expectations of Fed rate cuts, as investors largely disregard increasing risks to the Eurozone outlook. Regarding the Fed, yesterday’s partial pricing out of near-term easing expectations was welcomed, given that the pricing appeared to be stretched. With 90 basis points still factored into the overnight index swap (OIS) curve, there appears to be more room for further scaling back of expectations. However, it remains uncertain whether this will be realised this week, given the lack of market-moving data on today’s agenda. The Jackson Hole symposium next week, historically a hawkish event for the dollar, may serve as the next catalyst.

Global Markets Respond Positively to US Inflation Decline

Global markets welcomed yesterday’s news of US inflation easing for a fourth consecutive month, reaching its lowest level since early 2021. Headline inflation surprised analysts by coming in lower than expected at 2.9% annually and 1.6% on a three-month annualised basis in July. However, the only caveat in the Consumer Price Index (CPI) report was an unexpected 0.4% monthly increase in shelter costs—the largest component of the headline index—as rents are decreasing more slowly than initially anticipated.

Although the details of the CPI and Producer Price Index (PPI) readings, which contribute to the Federal Reserve's (Fed) preferred inflation measure (Personal Consumption Expenditures, or PCE), might cause the index to rise later this month, it is unlikely to hinder the anticipated start of the easing cycle. Generally speaking, price pressures continue to slow, which should provide the Fed with greater confidence to ease policy in the upcoming meetings. The focus has now shifted from whether the Fed will cut rates in September to how much easing is feasible. The answer is likely to depend on the forthcoming jobs report, which has replaced inflation data as the key factor influencing policy decisions in the second half of 2024.

Overall, this week’s inflation data has not significantly influenced markets or the Fed. US equity benchmarks traded slightly lower following the CPI report, while the US dollar and Treasury yields declined. The ongoing decrease in inflation is likely to remain a negative factor for the dollar over the next two to three months. Consequently, the direction of macroeconomic data will be crucial in determining market trends. Today’s retail sales report is the last major release this week; any signs of increasing recessionary risks could further weaken the dollar, while strong consumer spending could cast doubt on whether the expected 200 basis points of rate cuts over the next seven meetings are truly justified.

Modest UK Inflation Rise in July Fuels Expectations of Further Bank of England Rate Cuts

A smaller-than-anticipated increase in UK inflation in July has led traders to believe that additional rate cuts from the Bank of England (BoE) are on the horizon. Markets are now nearly fully pricing in two more 25-basis point reductions this year, compared to 44 basis points before the inflation report. The pound has faced some modest selling pressure, dropping over 50 pips against the euro, with €1.17 proving to be a key short-term resistance level.

UK Consumer Price Index (CPI) rose by 2.2% in July, and it is expected to inch higher as the effect of lower household energy prices fades from the annual comparison. However, this outcome was anticipated and forecast by the BoE. Instead, greater focus is on services inflation to guide policy, which recorded its lowest reading in over two years, standing at 5.2%, down from 5.7% in June and notably below the BoE’s 5.6% forecast. Survey data also indicate that businesses are raising prices less aggressively than before, and with wage growth also cooling, these conditions are likely to enable at least one rate cut, with the possibility of two more before the year’s end.

Why didn’t GBP/USD fall further yesterday? Despite UK yields declining in response to increased expectations of rate cuts, US yields also dropped after headline US CPI reached its lowest level since 2021, allowing GBP/USD to stabilise above its 5-year average of $1.28. The focus now shifts to the UK’s Q2 GDP, which met expectations this morning, having little impact on the pound. However, tomorrow’s retail sales data will provide further insights into the strength of the consumer and the economy in the third quarter.

EUR/USD Hits 2024 High as Softer US CPI Fuels Fed Rate Cut Expectations

EUR/USD climbed to its highest level in 2024 as US CPI figures came in lower than expected, raising hopes for a Federal Reserve rate cut in September. However, traders who were expecting an even softer reading were left disappointed, as the likelihood of a significant 50-basis point Fed rate cut in September now seems increasingly difficult to justify. Despite a rise in short-term US Treasury yields, the euro remained strong, buoyed by improving sentiment that favoured the pro-cyclical currency.

Domestic macroeconomic data was mixed and largely overlooked by market participants. Final estimates showed that France’s annual inflation rate in July increased to 2.3% year-on-year, slightly below the preliminary estimate. The second estimate of Eurozone GDP matched expectations, but employment growth was weaker than anticipated, hinting at potential challenges ahead. Additionally, June industrial production fell by 3.9% year-on-year, surpassing the expected 2.9% decline. In fact, Eurozone industrial production has contracted every month in 2024 on a year-on-year basis. With the manufacturing sector remaining weak and showing little sign of recovery, it is likely to weigh on growth in the third quarter of 2024. As a result, Eurozone growth is likely to rely more heavily on the services sector for the time being.

The Euro Index advanced by over 0.3% on Wednesday, supported by a modest gain against the New Zealand dollar. EUR/GBP rose by as much as 0.3% to £0.858 as UK inflation increased less than expected, boosting short-term Bank of England rate cut expectations. Meanwhile, EUR/JPY approached a two-week high following the news that Japanese Prime Minister Fumio Kishida will not seek a second term.