Dollar Pauses Near 3-Month High

The Federal Reserve’s Beige Book once again depicts a sluggish US economy, seemingly at odds with the official data. However, this has had little impact on the markets. Instead, several bullish factors are driving the US dollar higher. There is a revival of the US exceptionalism narrative, and the rise in fixed-income volatility, with US yields hitting 3-month highs, is further supporting the dollar. Additionally, geopolitics and domestic politics are lending another layer of strength to the dollar, particularly as improved polling for Donald Trump ahead of the upcoming US election boosts confidence.

Beyond the resurgence of US economic exceptionalism, which is pushing the dollar and yields higher, market sentiment remains convinced that the Republicans are on course for an electoral win. Should this materialise, an increase in tariffs could strengthen the dollar by affecting risk sentiment and slowing trade. If higher tariffs also lead to greater inflation and influence the Federal Reserve’s policy stance, this would provide further support for the dollar through monetary policy channels. In the foreign exchange market, traders are preparing for such an outcome, with EUR/USD two-week implied volatility, which now captures the aftermath of the US election for the first time, recording its second-largest daily jump since the onset of the Covid-19 pandemic in 2020.

Elsewhere in North America, the Bank of Canada joined other central banks with a 50-basis point rate cut yesterday. The yield spread between US and Canadian two-year bonds is now at its widest since 1997, which may continue to put downward pressure on the Canadian dollar, also known as the "Loonie", a trend that could be exacerbated by a Republican victory in the coming weeks.

Sterling Slips Over 3% Month-to-Date

The British pound fell below its 100-day moving average yesterday, trading near $1.29, marking a decline of over 3% month-to-date against the US dollar. The ongoing strength of the dollar is driving the pair lower, and dovish comments from Bank of England Governor Andrew Bailey are further weighing on sterling as traders brace for the release of flash PMIs later this morning.

Bailey suggested that disinflation is occurring faster than expected, hinting that the central bank may continue lowering rates next month. Despite progress on inflation and a cooling in wage growth, traders remain cautious in betting that the BoE will cut rates in both November and December. Although rate expectations haven’t shifted significantly following Bailey’s remarks, and UK gilt yields continue to rise, sterling remains vulnerable to fluctuations in global risk sentiment, falling equities, and broad-based dollar strength as traders pare back expectations for Fed rate cuts and position themselves for what is likely to be a closely contested US election. The clear break below the 100-day moving average opens the door to the 200-week moving average at $1.2850 and the 200-day moving average, which is situated lower at $1.28.

Today’s focus will be on flash industry PMIs, which are expected to show continued expansion in the UK, with all readings anticipated to remain above 50. In September, employment, new orders, and future output expectations in the manufacturing sector fell, likely due to uncertainty surrounding the Budget. Meanwhile, the services sector has remained more resilient, experiencing over a year of expansion, driven by strong domestic demand. This highlights the contrasting performance between the UK and the Eurozone, where activity is contracting, helping the GBP/EUR rate stay around €1.20.

No Free Trade Agreement Spells Trouble for the Euro

The euro has faced numerous challenges over the past four weeks, including disappointing macroeconomic data from Germany, inflation below target in many Eurozone countries, and rising expectations of further monetary policy easing. Political uncertainty surrounding the US election has also weighed on the single currency.

However, deteriorating risk sentiment and falling stock markets have not been part of this narrative – until now. This week has seen a shift, with the S&P 500 on track to record its first weekly loss in eight weeks and volatility, both implied and realised, continuing to rise. This has pushed EUR/USD below $1.08, with $1.0750 now coming into focus.

The euro is not the only currency feeling the pressure of investors positioning themselves ahead of the US election. However, the absence of a free trade agreement (FTA) between the United States and the European Union suggests that economic pain may be on the horizon in the event of a Trump victory and an increase in tariffs. EUR/USD implied one-month volatility has now reached its highest level since early 2023, at 8.3%, and the premium on call options for the same period indicates that investors are more inclined to hedge against further downside risks rather than upside possibilities.

Treasury Yields Climb Higher

Speculative FX traders have made their most significant move in three years ahead of the US presidential election. Hedge funds and asset managers reduced their short positions against the US dollar by approximately $8 billion in the second week of October. This marks the most substantial shift in sentiment since 2021. Meanwhile, the US dollar index has risen for four consecutive weeks, gaining nearly 4% to reach its highest level in over two months, as US yields climb to fresh three-month highs.

Several factors are boosting demand for the US dollar: US economic outperformance, reduced expectations of Federal Reserve rate cuts, and improving polling for Donald Trump ahead of the election. A potential Trump victory, seen as the more significant market event, could also prompt additional safe-haven flows into the dollar, especially if further risk aversion leads to a notable reduction in liquidity. At the same time, bond markets are under pressure, grappling with concerns that the Federal Reserve may not cut interest rates as much as expected. The MOVE index, which measures expected volatility in the fixed-income market, is now near its highest level this year. This has dampened risk appetite, weakening risk-sensitive currencies while supporting the safe-haven dollar.

Today, attention turns to the Fed's Beige Book on economic conditions. The previous report showed stagnant or declining activity across much of the US, which was one of the reasons behind the Fed’s decision to implement a larger-than-expected rate cut last month. Could another weak report halt the dollar’s upward momentum? Given the US economic surprise index is at a five-month high, this seems unlikely.

Pound Drops to Two-Month Low

The British pound has fallen to its weakest level against the US dollar since mid-August, currently hovering around its 100-day moving average at $1.2865. A decisive break below this level could open the door to the 200-day moving average at $1.28, although the 200-week moving average at $1.2850 should provide strong support.

The currency pair is weighed down by relative growth differentials and safe-haven demand, compounded by a more dovish outlook for Bank of England (BoE) rate expectations. Markets are now pricing in a 70% chance of the BoE implementing a second 25 basis point rate cut in December, following one anticipated in November after weaker-than-expected UK inflation data last week. Investor concerns over bond market volatility are further pressuring the risk-sensitive pound, despite UK yields rising this week. However, sterling remains strong against the euro, holding above the €1.20 mark, buoyed by a widening short-term rate differential, with the two-year spread at its highest in 10 months. GBP/EUR is now around 12% higher than its 2022 low, up 4% year-to-date, and five cents above its five-year average.

There is little economic data on the agenda today, but the release of flash purchasing managers' indices tomorrow could trigger currency volatility, especially if we see any further divergence in economic performance among major economies.

Volatility Puts $1.08 at Risk for Euro

The euro hit a new two-month low during yesterday's session, pressured by rising US Treasury yields and the prospect of a Trump 2.0 presidency. Euro sellers have pushed EUR/USD below the $1.08 mark this morning, as a series of European Central Bank (ECB) speakers failed to generate bullish momentum.

In an interview yesterday, ECB President Christine Lagarde expressed confidence that the inflation target will be sustainably achieved by 2025, following reassuring recent data. She joins a growing list of dovish ECB policymakers, which has led markets to lower their expectations for the ECB’s policy rate. The likelihood of a 50 basis point cut in December is now around 20%. ECB policymaker Mario Centeno has also called for a gradual and steady reduction in interest rates, reflecting a preference for a smaller 25 basis point cut at the year’s final meeting.

Risks to economic growth clearly remain tilted to the downside, but much of the recent pessimism surrounding negative news appears to be priced in, which could be favourable for the euro. Nevertheless, the approaching US election is likely to keep buyers cautious for the time being. US investors have turned net-long on the equity volatility index for the first time this year, and fixed-income volatility has surged to its highest level in 2024. These developments do not bode well for EUR/USD, especially now that the $1.08 threshold has been breached.

Dollar on the move

With no clear bearish drivers for the US dollar, its recent recovery from over a one-year low last month appears set to continue in the near term. The first phase of the dollar’s resurgence was driven by the strength of the US economy, but the second phase may be shaped by political factors. Both dynamics are pushing bond yields higher, not only in the US but across most major economies.

The resilience of the US economy goes beyond the impressive jobs report for September and the drop in the unemployment rate. Retail sales and the ISM services index also exceeded expectations. In addition, core inflation has gained momentum, signalling that inflation remains a persistent issue. Consequently, expectations for a quick reversal in Federal Reserve policy have been scaled back, fuelling a yield-driven rally in the dollar. Aside from the US’s economic strength, geopolitical and domestic political developments are providing further support for the dollar. Gold hit a record high on Monday, as tensions in the Middle East and a tightening US election race prompted a flight to safe-haven assets, including the US dollar.

The outcome of the US election is also crucial. Improved polling for Donald Trump could reinforce the upward momentum in bond yields and the dollar, given the potential implications for trade, fiscal, and monetary policies. With the election essentially a toss-up, it’s challenging for traders to predict the outcome, which may explain why EUR/USD and GBP/USD are struggling at the $1.08 and $1.30 levels, respectively. However, a Trump victory could knock as much as 5% off these exchange rates by the end of the year.

Pound hit by rising global yields

UK bond yields surged this morning across the yield curve, mirroring movements in major economies across the US, Europe, and Asia. Traders are trying to anticipate the future path of global interest rates, and with central banks in the G3 economies pricing in less easing over the next 24 months, the pound and other pro-cyclical currencies have faced renewed selling pressure against the US dollar. This trend has been evident since the interest rate hiking cycle ended in 2022.

The situation is largely driven by developments in the US. The resilience of the US economy has surprised market participants and central bank policymakers alike, prompting traders to scale back aggressive rate cut expectations. However, in the UK, signs of moderating inflation, a loosening labour market, and weakening economic momentum should, in theory, have increased the likelihood of rate cuts. A 25-basis-point cut is fully priced in for November, with a 70% chance of another in December, but the recent surge in bond yields suggests some uncertainty among bond traders about back-to-back cuts. Additionally, with the Bank of England no longer seen as an outlier in hawkishness, and overall G3 easing expectations being lowered, the pound has struggled against the dollar.

GBP/USD is hovering around $1.30 today, down nearly 3% for the month, though it remains almost 3% higher year-to-date. It still sits two cents above its five-year average of $1.28, which also aligns with its 200-day moving average – a level it often gravitates towards, as seen in August. Meanwhile, GBP/EUR remains above €1.20, close to a two-year high, buoyed by favourable growth and yield differentials for the pound.

Break of $1.08 in sight

The rise in US Treasury yields across the curve has dominated market discussions at the start of the week. The euro, like many other pro-risk currencies, has been unable to resist the downward pressure caused by widening rate differentials and is once again nearing the $1.08 mark. EUR/USD seems to be largely driven by developments in the US, where enthusiasm for Trump-related trade policies has resurged.

The negative economic news from Europe has done little to support the euro. Recent remarks from top European Central Bank members, such as François Villeroy de Galhau, suggesting that inflation will fall below 2% early next year, have paved the way for further policy easing. The ECB is expected to cut rates in December, followed by quarterly reductions throughout next year, which could see the deposit rate fall to between 1.75% and 2.0% by the end of 2025.

German producer inflation for September also came in lower than expected, with the PPI falling by 1.4%, compared to the anticipated decline of 0.8%. Christine Lagarde is scheduled to speak three times over the next two days, though it is unlikely her comments will shift market expectations regarding the ECB’s next policy move.

Pound Sterling Rebounds After Dropping Below $1.30 Amid BoE Rate Speculation

Last week, the pound fell below $1.30 at interbank (IB), marking its lowest level in over two months against the US dollar. This decline was driven primarily by the strength of the USD and increased speculation of potential Bank of England (BoE) rate cuts following UK wage and inflation data. However, the release of Friday's UK retail sales report provided some relief, pushing the GBP/USD exchange rate back above $1.30. Additionally, the GBP/EUR pair surged to new 2-year highs, climbing above €1.20 at IB, a level it has exceeded for only 3% of the post-Brexit period.

EUR/USD Recovers Slightly After ECB Rate Cut and US Election Concerns

The EUR/USD pair rebounded from a brief dip to $1.0810 at IB, closing the trading session around $1.0860 at IB. Despite this recovery, the euro remained lower over the week, pressured by the strength of the US dollar amid heightened election-related concerns. The European Central Bank (ECB) further weighed on the euro by cutting its deposit rate by 25 basis points to 3.25%, a move widely anticipated by the markets. ECB President Christine Lagarde’s cautious outlook on the European economy, citing weaker-than-expected growth, fuelled speculation that additional rate cuts may be necessary in the future.

Pound Sterling Uptrend Against Euro Expected to Continue, But Volatility Looms

The pound sterling is poised to extend its upward trend against the euro over the next five days. However, traders should be cautious of potential volatility driven by upcoming Bank of England speeches and the release of Thursday's PMI data.  BoE Governor Andrew Bailey is scheduled to speak this Tuesday, along with several other members of the Monetary Policy Committee (MPC).There is a risk that Bailey might interpret recent data as justification for accelerating the pace of interest rate cuts by the Bank.

Trump's Presidential Prospect Boosts Dollar Amid Election Volatility Concerns

The possibility of Donald Trump winning the presidential election is bolstering the US dollar, as his policies on tariffs, taxes, and immigration are viewed as inflationary, potentially leading the Federal Reserve to keep interest rates elevated for a longer period. A Republican clean sweep is seen as the greatest volatility risk, with traders increasingly positioning themselves for the election over the next two weeks.