China’s Economic Struggles Persist

The cyclical segment of China’s economy remains under pressure due to fiscal limitations, weak domestic demand, and anticipated higher tariffs. Loan growth hit a record low in July, paralleling the unprecedented drop in Chinese bond yields across the curve. August didn’t fare any better, with the official composite PMI falling to its lowest point since December 2022. The manufacturing index stayed in contraction for the fourth month in a row, with all sub-components dipping below the 50 mark last month. This phenomenon has only occurred 12 times since 2005, all post-pandemic. The week’s first data release came from China, shifting focus to the US PMI for manufacturing, which will influence FX markets.

Seasonal Factors Could Impact Sterling

Sterling started September positively, bolstered by the final UK manufacturing PMI for August, which showed UK factory activity growing at the fastest rate in over two years. This marked the fourth consecutive month of expansion, suggesting a continued economic recovery in the UK for Q3.

This positive result starkly contrasted with the declining manufacturing activity across Europe. The Eurozone’s manufacturing PMI confirmed the sector remained in contraction in August, dragged down by Germany and France. The UK’s better-than-expected economic data, along with cautious comments from Bank of England (BoE) Governor Bailey on further rate cuts, have reduced expectations for UK rate cuts. Markets are now pricing in just 40 basis points of rate cuts from the BoE by year-end, compared to 60bps from the ECB. Consequently, the EUR/GBP 2-year swap rate gap has widened to its largest since February, favouring sterling. As a result, GBP/EUR remains strong just under €1.19, over three cents above its 5-year average.

However, after three consecutive weekly gains, GBP/EUR might lose momentum. Seasonal trends are negative for sterling, as September has historically been the worst month of the year for the pair since 2000. A significant decline would require a substantial increase in BoE easing expectations, making next week’s UK labour market data and the following week’s inflation data critical.

Political Uncertainty Rises in Europe

After climbing to a one-year high above $1.12 last week, EUR/USD lost momentum and settled back into the $1.10 range. The impact of Fed-driven dollar weakness appears to be largely priced in, and the yield-driven bullish case seems to have lost steam as ECB rate-cut discussions resurface following last week’s Eurozone inflation report, which hit a three-year low. Additionally, rising political risk in Europe is seen as a challenge for the common currency.

In France, the search for a premier remains unresolved, while over the weekend, populist parties on the extreme right and left made significant gains in German regional elections. Germany’s euro-sceptic party, Alternative for Germany (AfD), celebrated a major victory in the eastern state of Thuringia – its first state parliament win since World War Two. AfD also came a close second in the more populous neighbouring state of Saxony. With federal elections only a year away, the AfD is second in national opinion polls, potentially prompting calls for early elections. Given the earlier turmoil in France this year, investors might become cautious about the implications for European assets, including the euro.

Indeed, EUR/USD one-month risk reversals have turned negative again, indicating a rising premium to protect against a decline in the common currency.

GBP/EUR has been on an upward trend against the Euro for six consecutive months. However, its recent recovery hit a barrier at 1.19, suggesting a potential pullback in the coming days. Last week, the Pound to Euro exchange rate climbed just above 1.19 before retreating, marking this level as a significant resistance point. At 1.19 GBP/EUR, there is notable support at 0.84 in EUR/GBP, which could attract some buying interest in the euro. On the Dollar, Cable managed to break through 1.32 last week and maintained some semblance of support in or around that level.

The RSI indicator is turning downwards, indicating waning momentum and the possibility of a downside movement soon. Despite this, the overall trend remains positive, and any pullbacks are expected to be minor. Support is now at 1.18, aligned with the 50-day moving average. We anticipate the exchange rate to stay above this level if new highs for 2024 are to be achieved in the coming weeks.

The Euro declined last week following lower-than-expected inflation data from Germany and Spain, increasing the likelihood of consecutive rate cuts by the European Central Bank in September and October. However, expectations for an October rate cut became less certain after Eurozone-wide CPI data released on Friday showed rising services inflation, indicating that the disinflation process might be stalling. If expectations for ECB rate cuts diminish further, the Euro could stabilize against the Pound.

With no major data releases from the Eurozone or the UK this week, the GBP/EUR exchange rate will likely be influenced by global risk sentiment. Typically, the Pound rises with positive sentiment and falls when markets retreat. This week is crucial for investors as the final U.S. payroll report before the Federal Reserve’s September interest rate decision is due. While a rate cut later this month is almost certain, the guidance will be key. For the Fed to consider further cuts, evidence of a cooling labour market is needed, making Friday’s report significant. A strong recovery in payroll data could cast doubt on additional rate cuts, potentially boosting the Dollar and impacting stocks negatively.

US Dollar Rises Slightly After Upward GDP Revision, But Faces Worst Month of 2024

The US dollar edged higher on Thursday following revised data showing that the US economy grew at a marginally stronger pace in the second quarter than initially reported. Despite this uptick, the dollar has declined each week this month and is on track to record its worst performance of 2024.

The revised estimate for the second quarter's real GDP increased to 3.0%, up by 0.2 percentage points from the previous estimate, driven by stronger consumer spending. However, downward revisions to investment and other key categories tempered the overall outlook. Confidence remains high that the Federal Reserve (Fed) will soon begin easing monetary policy, encouraging traders to seek higher yields in currencies like the New Zealand dollar and Swedish krona. While the US dollar is attempting to recover some recent losses, a significant rebound appears unlikely if market expectations about the Fed hold true.

Next week’s August jobs report could reveal further labour market weaknesses, potentially prompting the Fed to initiate its easing cycle with a more aggressive 50-basis-point rate cut in September. Meanwhile, the Fed’s preferred inflation measure, the PCE price index, is due today and could influence the dollar’s performance, especially if it exceeds expectations, providing some support as the month closes.

Pound Set for Largest Monthly Gain Since November Despite Pullback from 2-Year Highs

Despite the pound retreating from its 2-year highs against the US dollar, it remains on track to achieve its largest monthly gain since November, standing over 6% above its 2-year average rate of approximately $1.24. The Bank of England’s (BoE) broad sterling index is also approaching the July peak, which represents its highest level since the Brexit vote in June 2016.

In other currency pairs, GBP/EUR is nearing the €1.19 level—a mark it has surpassed for only 16 days in the past two years. The pound's strength has been fueled by stronger-than-expected UK economic data, contrasting with growing concerns in both the Eurozone and the US. This has led the BoE to caution against aggressive policy easing, with markets responding by pricing in just 40 basis points of cuts for this year. Consequently, FX options traders are more bullish on the pound's short-term prospects than they have been since 2020, as investors continue to reassess the relative interest-rate trajectories of the Fed and BoE.

However, with much of the Fed-driven dollar weakness already factored in, there’s no clear catalyst for the pound to push towards the $1.35 mark. Attention is now shifting to the upcoming decisions by the Fed and BoE, and particularly to UK Chancellor Reeves’ first budget at the end of October, which could play a pivotal role in determining whether sterling's bullish momentum can be sustained through the rest of 2024.

Euro Continues Decline Amid Softer European Inflation Data and Strong US Economic Performance

The euro extended its weekly decline to over 1%, dropping an additional 0.4% on Thursday due to weak preliminary inflation data from Europe and signs of robust US economic performance. Meanwhile, European stocks and bonds advanced as investors reacted positively to softer-than-expected German inflation figures, which are anticipated to influence the Eurozone's headline rate and fuel hopes for adjustments by the European Central Bank (ECB).

In August, Germany's preliminary annual inflation rate unexpectedly fell to 1.9%, below the forecasted 2.1% and down from 2.3% in the previous month. This marks the lowest rate since March 2021. On a monthly basis, the CPI edged down by 0.1%, contrary to expectations of a 0.1% increase. The EU-harmonised CPI also dropped to 2% year-on-year, below the anticipated 2.3%.

This downside surprise, along with similarly weak Spanish CPI data, has raised expectations that today's headline Eurozone inflation rate could come in lower than market consensus, increasing the likelihood of ECB easing. The central bank’s future policy path remains uncertain after it abandoned forward guidance in its July meeting. ECB official Patsalides indicated that further rate cuts are likely if the ECB's projections continue to hold. If the Eurozone inflation figure today comes in below expectations, European bonds are expected to advance further, which would be negative for the euro. However, the impact will largely depend on progress in the services and core inflation metrics, which have remained stubbornly high throughout the year.

Market Dynamics Reflect Growing Expectations for Fed Rate Cuts Amid Economic Uncertainty

Investors are increasingly positioning for anticipated rate cuts by the Federal Reserve, following Chair Powell’s dovish remarks at the Jackson Hole conference. Swap prices suggest a consensus of around 100 basis points in rate cuts across the Fed’s three remaining decisions this year, implying at least one significant 50 basis point reduction. However, recent signs of resilience in U.S. economic growth, highlighted by a sharp rebound in durable goods orders, have raised doubts about the extent of the upcoming easing cycle. With the high threshold for further dovish adjustments, a major decline in the USD may require markets to fully anticipate a U.S. recession. In this context, the absence of major U.S. economic data this week could benefit the dollar, though initial jobless claims might draw increased attention as the labor market has become a key indicator for gauging the Fed’s potential easing path.

The prevailing Fed narrative is broadly negative for the dollar, driven by expectations of aggressive policy easing. This sentiment shift is evident in recent positioning data, where speculators have turned bullish on the euro, pound, and yen against the dollar for the first time since early 2021.

Sterling Resilient Amid Global Risk Sentiment Despite Limited UK Economic Data

With no major UK economic data releases, sterling remains vulnerable to global risk sentiment, yet the currency has shown resilience despite a modest increase in risk aversion in financial markets this week. GBP/USD continues to hold firm at $1.32, a level it has only surpassed for four days over the past two years, while GBP/EUR hovers near €1.19, a threshold exceeded for just 16 days in the same period.

In early August, the Bank of England (BoE) reduced its main rate by 25 basis points to 5%. Markets are currently anticipating an additional 40 basis points in cuts by the end of the year. However, stronger-than-expected UK economic data and cautious comments from BoE Governor Andrew Bailey on further rate reductions have moderated these expectations. Consequently, both 2-year and 10-year UK gilt yields have risen above 4%, enhancing the pound's yield advantage against most major currencies. While there is potential for further short-term weakening of sterling, GBP/USD has already corrected from overbought levels due to recent consolidation.

On the fiscal front, UK Prime Minister Keir Starmer has acknowledged the challenges ahead in addressing issues linked to the previous Conservative government, warning that conditions may deteriorate before they improve. The upcoming Autumn budget, along with anticipated tax increases, adds some uncertainty to the UK's growth outlook.

German Inflation Drops to Lowest Level Since 2021 as Eurozone Awaits Further Slowdown

Germany's annual inflation is expected to decrease to 2.1% in August, marking the lowest level since April 2021. Similarly, Eurozone inflation data, set to be released tomorrow, is projected to show a slowdown to 2.2% year-on-year, the lowest in over three years and down from 2.6% in July. Despite these indications of cooling inflation, market expectations for European Central Bank (ECB) rate cuts remain unchanged. Traders are holding steady on their bets, pricing in a 25bps cut next month, 65bps by the end of the year, and 157bps by the close of 2025.

The EUR/USD pair has retreated to a three-session low of around $1.112, extending its losses for the week. The pair has shed approximately 0.7% from its recent high but still remains nearly 3% higher for the month. With markets pricing in the bottom of the dollar smile scenario and no significant U.S. economic data this week, the dollar is likely to maintain its strength. Consequently, EUR/USD may struggle to climb back toward $1.120, with a potential retest of the $1.110 support level on the horizon.