Robust Spending and Strategic Rate Cuts

Throughout 2024, US exceptionalism has been a key theme, bolstering the dollar, bond yields, and equities. Yesterday, the dollar hit new 11-week highs, while stocks rose and bonds dipped, driven by a solid US retail sales report. Jobless claims also dropped by 19,000 to 241,000, reversing a spike from the previous week’s storm-related disruptions. In essence, the US economy is showing strength, making it likely that the Federal Reserve will proceed with cautious rate cuts.

In September, US retail sales grew by 0.4% month-on-month, far exceeding the 0.1% increase seen in August and beating market expectations of a 0.3% rise. This suggests another strong quarter of economic growth, underpinned by solid consumer demand, income growth, access to credit, and a resilient labour market. While the Fed is still expected to cut interest rates by 25 basis points next month, the robust retail figures add weight to the "no landing" thesis, signalling that consumer spending remains buoyant.

Looking ahead, the swaps market now reflects expectations of around 125 basis points of rate cuts through the seven scheduled Fed meetings up to July 2025, indicating the likelihood of two pauses during this period.

Pound Rallies on Strong Retail Sales

Retail sales in the UK unexpectedly rose by 0.3% month-on-month in September 2024, following a 1% increase in August, beating forecasts of a 0.3% decline. Sales at non-food stores surged by 2.5%, driven by strong demand for computers and telecommunications equipment. This positive data has given the pound a solid boost to close the week.

The British pound has climbed back towards $1.31 against the US dollar on the strength of these figures. The pound has also gained against the euro, reaching multi-month highs as the UK’s economic growth and yield differentials work in its favour. However, with several key risks on the horizon, the options market points to increasing downside risks for sterling. One-week and one-month risk reversals for GBP/USD are back in negative territory, indicating a growing preference for hedging against further declines in the pound or strength in the dollar.

Despite a slight retreat from its 2024 highs, one-month implied volatility for GBP/USD remains elevated at over 8%, which is two standard deviations above the year-to-date average of 6.6%.

Euro Weakens Amid Dovish ECB Stance

The euro has extended its three-week decline, weighed down by stronger-than-expected US data and a dovish European Central Bank (ECB) meeting. These developments reflect two major shifts that have turned against the euro. Earlier in the year, the rise of EUR/USD from $1.07 to $1.12 between May and September was based on expectations of a slowing US economy and a belief that the ECB would be less aggressive in cutting rates than the Federal Reserve. However, recent data suggests the US economy is gaining momentum, while economic disappointments in Europe are paving the way for further ECB easing, potentially as soon as December, which could lower the deposit rate to 3% by year-end.

Yesterday's 25 basis point cut was widely expected, with ECB President Christine Lagarde maintaining a data-driven, meeting-by-meeting approach. Yet, mounting downside risks to inflation have opened the door for further cuts. Markets now price in a 20% chance of a 50 basis point cut in December. However, a large cut seems unlikely for two reasons. First, the current easing cycle is already well underway, and a more aggressive move would signal that policymakers may have miscalculated previously. Second, while not stellar, recent economic data, including improved German sentiment and Eurozone industrial production, suggests some signs of recovery.

Looking ahead, the euro is expected to remain under pressure, particularly with the upcoming US election and the increasing likelihood of a Trump victory. The $1.0750 resistance level will be crucial to watch, though absent the political uncertainty, EUR/USD might have settled around $1.10. A win for Harris could push the euro higher, but for now, markets seem to favour Trump’s chances.

Trump trade rebounds

Despite a brief dip earlier this week due to easing tensions in the Middle East and a 5% drop in oil prices, the US dollar index has surged to a new 11-week high. Interestingly, 10-year US Treasury yields have declined, signalling that traders are seeking safety in bonds and the dollar ahead of several uncertain events on the horizon.

One of the key factors behind the dollar’s recent strength is the increasing likelihood of a Donald Trump victory in the US election, now just three weeks away. For the first time since Harris entered the race, Trump is leading in an average of the polls across seven swing states. Although the race remains incredibly tight, with just 0.34 percentage points separating the two candidates, the consistent shift in Trump's favour has caused concern among Democrats. Financial markets are also reacting. A Trump win is perceived as potentially inflationary, which could disrupt global trade and lessen the chances of further Federal Reserve rate cuts. This scenario points to higher yields, a stronger dollar (in the short term), and rising equities and cryptocurrencies.

Reflecting the uncertainty surrounding the election, the US equity volatility index (VIX) has remained above a key threshold for its longest streak in over two years. It is unusual for the VIX to stay above 20 when the S&P 500 closes at a new record high, as it has done recently. However, this extended period above that level often coincides with brief reversals in equity gains, which could negatively affect risk-sensitive currencies such as the AUD, NZD, NOK, and GBP. The US election typically impacts currencies most through risk and trade channels, meaning a Trump presidency would have a more pronounced market impact than a win for Harris, who is more focused on domestic issues.

Pound near two-month low

One-month implied volatility for GBP/USD remains close to its 2024 highs due to the upcoming US election and key central bank meetings. Seasonally, volatility tends to stay elevated towards the end of the year, especially in election years. However, it is not just the rising odds of a Trump victory and a stronger US dollar that are weighing on the pound. Expectations of a more dovish stance from the Bank of England (BoE) following weak UK economic data this week are also contributing to the pound's decline.

UK inflation fell to 1.7%, its lowest level in three years and 0.4 percentage points below the BoE's August forecast, driven by a notable reduction in services inflation, particularly airfares. Services inflation is now 0.6 percentage points below the BoE’s August projection. This reinforces the view that the BoE will implement two consecutive 25 basis point rate cuts from November onwards, in line with Governor Bailey’s recent statement that, if inflationary pressures continue to ease, the rate cuts could be more aggressive. This dovish shift is compounded by softening wage growth and expectations of slower GDP growth in the third quarter. These factors have pushed UK bond yields significantly lower, sending GBP/USD below the key psychological level of $1.30 for the first time since August.

The options market offers further insight into FX sentiment, with both 1-week and 1-month risk reversals for GBP/USD turning negative once again. This suggests a preference for hedging against further GBP weakness or USD strength. The next target is the 100-day moving average support level of $1.2954, followed by the 200-week moving average at $1.2844 and the 200-day moving average at $1.2794.

Euro slips as Trump gains momentum

The euro has declined in 14 of the past 16 trading sessions, with selling pressure building ahead of today’s highly anticipated European Central Bank (ECB) rate decision. Policymakers are widely expected to cut rates by another 25 basis points as part of their ongoing easing cycle.

A few weeks ago, markets were not anticipating rate changes. However, recent weak macroeconomic data and inflation consistently below target across much of Europe have prompted a more dovish stance from the ECB, with Governing Council members increasingly open to the idea of further cuts. The Federal Reserve, no longer expected to lead the easing cycle among developed economies, has also bolstered the outlook for the US dollar.

Adding to the euro’s struggles is the rise of Trump in betting markets and the growing likelihood of a Republican sweep. The euro’s downward momentum remains strong, but it appears to be nearing overstretched levels. A significant miss in US data may be needed to give the euro some respite.

UK Inflation Falls Below BoE Target, Pound Drops as Rate Cuts Loom

Headline inflation in the UK has dipped below the Bank of England’s (BoE) 2% target for the first time in three years. The September inflation rate came in at 1.7%, lower than the 1.9% forecast and the previous 2.2%. Core inflation also eased to 3.2%, versus the anticipated 3.4%. This larger-than-expected drop in inflation has led to a decline in the pound, alongside falling 10-year gilt yields, as the likelihood of more BoE rate cuts increases.

The BoE has been particularly focused on services inflation, which has influenced its monetary policy decisions. Governor Andrew Bailey’s recent comments suggested that the central bank might adopt a more aggressive approach to rate cuts if inflation continued to fall. In a significant development, services inflation dropped to 4.9%—the largest single-month decrease since 2020—compared to the forecasted 5.2% and the previous 5.6%. This data reinforces the ongoing disinflation trend in the UK, which is further supported by recent signs of a cooling labour market.

As a result, market expectations for rate cuts have shifted. Overnight index swaps are now pricing in a 30-basis-point rate cut in November, up from the 22-basis-point expectation before the CPI data, with a total of 44 basis points of easing anticipated by year-end.

The pound has taken a hit in response, with GBP/USD dropping from $1.3077 to just under $1.2990, its lowest level since mid-August. The next downside targets are the 100-day moving average at $1.2954, followed by the 200-week moving average at $1.2844, and the 200-day moving average at $1.2794.

Oil Price Drop Drives Dollar Weakness Despite Softer US Data

Despite recent weaker US economic data, we believe the primary factor behind the dollar's decline was the movement in oil prices. This is evident as the dollar's weakness occurred before the European markets opened, ahead of key macro data releases. Furthermore, the six-month correlation between EUR/USD and Brent crude oil is at its most negative level since early 2000. Oil prices fell sharply overnight, dropping by as much as 5.6% following reports that Israel would not target Iran’s oil facilities. This decline in oil prices reduced inflation expectations and subsequently led to lower US Treasury yields, particularly at the long end of the curve. Short-term yields also fell slightly, likely due to recent comments from Federal Reserve (Fed) officials hinting at modest rate cuts ahead.

Despite this, we expect the overall positive trend for the US dollar to persist, provided economic data stays resilient. Historically, both volatility and the dollar tend to strengthen in the lead-up to US elections. This is particularly relevant now that a 50 basis point rate cut from the Fed next month is off the table.

Stocks jump, oil slumps

US stocks jumped to a fresh peak, with the S&P500 notching its 46^th record close of the year, fuelled by a rally in the tech sector as investors look to earnings for vindication of their bets that the US will avoid a recession. The US dollar index continues to press higher, clocking its longest daily winning streak since 2012.

As we’ve seen this month, a measure of underlying US inflation in September came in hotter than expected, while the most recent snapshot of the US labour market showed a drop in unemployment amid solid hiring. This has prompted investors to pull back bets the Fed will again cut its benchmark interest-rate by an outsize 50bps at its upcoming meeting in November. Thus, relative growth and yield differentials remain bullish drivers of the dollar, as does safe haven demand, amidst multiple geopolitical risks. However, Israeli Prime Minister Benjamin Netanyahu agreed to limit retaliation against Iran to military targets, which has triggered a 4% drop in oil prices overnight. Extended declines in oil prices in the short term appear likely amid signs of easing geopolitical risks combined with lingering doubts around the effect of China’s stimulus.

This could cool dollar demand. We are expecting a period of consolidation or a pullback in the dollar index, despite the plethora of bullish drivers, mainly due to it being overbought via the Relative Strength Index on the daily chart, but also because of the lack of fresh positive catalysts.

Pound still soft after mixed jobs data

The British pound remains on the soft side after a mixed set of data on the UK labour market. The unemployment rate fell to 4% as expected, marking the lowest level since the three months ending in January. Average weekly earnings including bonuses were up 3.8% y/y as expected, but marked a fresh low since November 2020.

The other key takeaways from the jobs report saw payrolled employees decreased slightly by 15,000, more than the 3,000 forecast, but rose by 113,000 y/y. Economic inactivity dropped to 21.8%, whilst vacancies continued to decline for the 27^th consecutive quarter, now at 841,000. The vacancies to unemployment ratio remains around one standard deviation higher than the 2000-2019 average. The bottom line is that a cooling UK labour market is bringing down wage growth, which will please Bank of England (BoE) policymakers. The BoE is keeping a close watch on these indicators as it seeks to gauge how far inflationary pressures in the economy are easing and therefore how fast to cut interest rates. Traders are more likely to wait for tomorrow’s CPI data though in assessing whether the BoE delivers a quarter-point interest-rate cut in November.

As such, pricing of BoE rate expectations barely moved after today’s jobs data. UK gilt yields are slightly higher, but GBP/USD remains in the middle of its $1.30-$1.31 range its been stuck within for most of October. GBP/EUR is moving closer to €1.20 though as a result of EUR/USD dropping below $1.10.

Euro trending below $1.09

The euro continued to build on its losses from last week and fell to a fresh two-month low at $1.0880. The negative momentum remains the driving force behind the move as investors await crucial US data and the rate decision from the European Central Bank (ECB) later this week for new impetus.

With a depreciation of around 2.2%, October is shaping up to be the worst month for EUR/USD year-to-date. This would be in line with both seasonality trends and previous US election cycles as the euro falls going into Q4 and the election. Former president Donald Trump’s rise in betting markets has been beneficial for the US dollar and stocks of companies that would benefit from a red sweep.

This repricing could continue to pressure pro-risk currencies and EM FX. The results of the ECB’s lending survey and Eurozone industrial production coming up later today could become new catalysts for confirming the weakness in the euro or stopping its fall for now.