Pound's Journey: From Best to Worst Performing G10 Currency

The pound has shifted from the best-performing G10 currency this year to the worst in August, influenced by fluctuating global risk appetite and increasing bets that the Bank of England (BoE) will cut interest rates twice more this year. Despite this, the BoE remains the least dovish among its G3 peers, and today's mixed UK jobs report further complicates the policy outlook. Sterling has ticked higher, currently trading around $1.28 and €1.17 against the USD and EUR respectively.

UK Job Market Surprises as Wage Growth Cools

In the three months to June, the UK economy created more jobs than expected, causing a surprising drop in the unemployment rate from 4.4% to 4.2%, below the forecast of 4.5%. However, wage growth slowed to its lowest pace in nearly two years, falling from 5.8% to 5.4%, signalling a cooling labour market. Despite distortions in the labour market survey, the wage figures align with officials' expectations, leaving rate forecasts unchanged. Meanwhile, CFTC data shows a significant reduction in GBP longs last week, despite their proximity to multi-year highs. Sterling remains vulnerable as crucial data, including inflation figures tomorrow and preliminary GDP data on Thursday, could influence future bets.

Inflation Outlook and BoE Rate Cut Speculation

Wednesday's inflation data is expected to show a 2.3% year-on-year rise in consumer prices for July, consistent with June's target. However, core and services inflation, which are more closely watched, are expected to soften. Consequently, UK overnight indexed swaps are increasingly pricing in nearly two rate cuts from the BoE before year-end.

FX Market Volatility and Caution Amid US Slowdown Concerns

FX markets have experienced a turbulent summer, driven by increasing concerns about a more pronounced US economic slowdown and questions about the Federal Reserve's prolonged high-interest rates. However, with volatility indices stabilizing and a positive ISM services report in the US easing recession fears, risk appetite has firmed, supporting pro-cyclical FX and reducing haven demand.

A slowing US or global economy presents a complex scenario for FX markets: a slowdown from above-trend output typically pressures the US dollar, but a slowdown leading to a negative output gap tends to support the dollar due to its safe-haven status. Currently, stability in equity markets has led investors to adjust their expectations for the Fed’s September meeting, now anticipating a 25-basis point rate cut instead of the previously expected 50 basis point cut. Short-dated yields have stabilized above 4%, and the US dollar index is around 103. Despite weakening growth and yield appeal, this transition phase introduces near-term downside risks for the US dollar without necessarily overturning the strong dollar regime, especially with ongoing structural factors such as protectionism/tariff risks and increased US fiscal stimulus.

Today, the focus is on NFIB small business optimism and US producer prices. Investors may breathe a sigh of relief if July’s headline and core PPI come in softer than June as expected. However, geopolitical tensions persist, with the US warning of a potential Iranian attack on Israel this week, which could limit any risk rally and keep the safe haven dollar in demand.

Euro Stays Steady as US CPI Report Looms

Financial markets started the week calmly, with the European equity index Stoxx50 ticking marginally higher on Monday and demand for government bonds easing. The EUR/USD pair remained stable, fluctuating within a narrow range of $1.0915-$1.0935 as investors adopted a cautious approach ahead of the crucial US CPI report scheduled for later this week. Volatility is expected to remain subdued until this data release.

Germany’s ZEW Economic Sentiment report for August is due soon, with expectations of further deterioration marking the second consecutive month of decline. The eurozone’s private sector growth stalled in July, with Germany dragging down the region’s overall performance. The German economy is teetering on the edge of stagnation, especially after the unexpected contraction in the second quarter. If the ZEW report confirms a bleak outlook, it could reinforce concerns about Europe’s growth prospects. However, the impact on the euro may be limited, as investors focus more on US macroeconomic data for cues on the EUR/USD direction.

Geopolitical tensions, particularly the ongoing Russia-Ukraine conflict, remain a background concern for investors. The recent rise in European gas prices to €41.4 per megawatt-hour, a nine-month high, underscores the potential risks. Historical patterns from 2022 suggest that any significant increase in fossil fuel prices tends to benefit the US dollar, as it signals broader economic risks that drive investors toward safer assets like the greenback.

The Pound to Euro exchange rate has stabilized after giving up much of its second-quarter gains in early August. It is expected to trade within a range of approximately 1.1639 to 1.1711 this week. Last week, GBP/EUR steadied above 1.16 and around the middle of its first-quarter range as stock markets rebounded from early August’s losses, and low-yielding funding currencies retreated from recent highs. Despite this stabilization, Sterling remained one of the weaker G10 currencies. However, improved risk appetite in global markets and a relatively higher yield could push the pair toward the upper end of the 1.1639 to 1.1711 range in the coming days.

The Pound to Dollar exchange rate has also stabilized following a sharp decline in late July and early August. There are several reasons to believe it could recover further in the days ahead, potentially retesting the 200-week average around 1.2845. GBP/USD steadied atop its 200-day moving average at 1.2661 last week before recovering some recent losses. Improved global market risk appetite, recent US election polls, and inflation expectations on both sides of the Atlantic could support further gains.

Democratic Party presidential candidate Kamala Harris has gained an advantage over former President Donald Trump in recent opinion polls. This shift undermines a significant support factor for the US dollar, as Trump's protectionist trade policies and tariff strategies are seen as positive for US business investment, production, employment, and GDP. However, an immediate boost for GBP/USD is likely to come from inflation data from both sides of the Atlantic on Wednesday. Ongoing disinflation in the US could lead markets to bet on the Federal Reserve cutting interest rates by as much as 100 basis points by year-end, weighing on the Dollar. Meanwhile, UK inflation poses an asymmetric upside risk to Sterling.

Market Turnaround: A Week in Review

This week in macro and markets is ending very differently than it started. Monday saw the unwinding of trades that had been popular over the past 6-12 months, such as long positions in technology stocks and short positions in volatility and the Japanese yen. The Nasdaq and USD/JPY dropped briefly by 6% and 3.5% respectively, as implied volatility in the US, Europe, and Japan experienced record intra-day spikes. However, by mid-week, global financial markets seemed to have calmed.

Dovish remarks from the Bank of Japan addressing the turmoil, along with positive macroeconomic surprises from the United States, have reassured investors, helping to stabilize equities, yields, and the dollar-yen exchange rate. The VIX has nearly retraced its gains, dropping from 75 to 25. The US Dollar Index is back in positive territory for the week, and short-term bond yields are higher than they were on Friday. Nonetheless, there remains uncertainty about the true extent of the global carry trade.

Historically, the intra-year drawdowns of 9% for USD/JPY and 6% for the G10 Carry Index are not significant over the past 30 years, suggesting that these trades are not overly stretched. The expected convergence of policies between the BoJ and the Fed, along with politically induced volatility around November, are likely to drive further unwinding of short yen positions. Next week, attention will be focused on US inflation data (PPI, CPI) and retail sales. USD/JPY will remain the most closely watched currency pair globally.

Inflation Data in Focus Next Week

GBP/USD has been under pressure due to risk aversion, which has favored the safe haven dollar over the procyclical pound. The downward momentum slowed at the 100-day and 200-day moving averages just below $1.27. Sterling has rebounded from over a one-month low, and short-term rate differentials indicate that further downside risks are limited.

While weak seasonals could limit gains in August—historically averaging around -1% since 2000—the 1-year swap spread between the pound and dollar suggests that the decline in GBP/USD is overdone. Since early July, sterling has dropped about 3% against the dollar, coinciding with global equity declines as investors sought refuge in safe haven currencies. Despite this, 1-year swap spreads remain elevated, indicating potential upside for the pound. Persistent core and services inflation in the UK has markets pricing in fewer than two 25-basis point cuts by the Bank of England by year-end, compared to the Fed's expected four quarter-point cuts.

Next week’s UK and US inflation data will provide more clarity on this pricing. For GBP/USD to make another run at $1.30, UK inflation needs to stay high, US inflation must surprise lower, and technically, the pair needs to break and hold above $1.2810, the 38.2% retracement from the July high to August low.

Euro Steady Above $1.09, Awaiting Clearer Signals

With a quiet day for European macroeconomic releases and bond supply, market focus was on US initial jobless claims data for signs of a potential slowdown in the US labor market. EUR/USD spot rates fell slightly after the report surprised to the downside, easing concerns about the US economy.

In Europe, stock performance was mixed as sentiment stabilized. German bonds, which initially gained, reversed after the US jobless claims data. The 10-year Bund yield held steady at 2.26% after briefly dipping to 2.22%, reflecting a slightly steeper curve as traders adjusted to recent volatility and sought a new yield equilibrium. Despite ongoing concerns about European growth, the market has become more comfortable with less aggressive near-term expectations for the ECB. Year-end rate cut expectations priced into the OIS curve have decreased to about 69 basis points from around 94 at the week's start.

With an empty economic calendar on both sides of the Atlantic, euro volatility is expected to decrease today. The short-term market sentiment in EUR/USD, indicated by 1-week risk reversals, is now neutral. However, this does not mean all risks have subsided. The EUR/USD volatility surface has shifted upwards, with one-month convexity reaching a two-year high, signaling continued caution among market participants.

Market Rebound Continues Amid Easing Volatility and Focus on US Jobless Claims

Equities have continued their rebound, cryptocurrencies have surged higher, and the US dollar is grappling with pro-cyclical foreign exchange as the recent financial panic subsides. This renewed risk appetite is supported by a modest decrease in volatility, though the VIX "fear index" remains significantly above its long-term average. Today's focus is on the weekly US jobless claims figures, following last week's sharp slowdown in payroll growth and rise in unemployment, which heightened recession concerns.

On Monday, our financial sentiment index turned negative for the first time this year due to the flight to safety, increased demand for downside protection, and spike in market volatility. This shift has provided some support for the US dollar against its pro-cyclical counterparts. However, with US economic growth weakening and the Federal Reserve expected to begin its easing cycle in September, we anticipate further dollar depreciation in the medium term. The extent of this decline will depend on the global growth outlook and US political developments.

Traders are speculating that the Fed might start its loosening with a larger-than-average 50-basis point cut in September, but significant deterioration in the labor market would be necessary for such an aggressive move. Unless next week's US CPI data presents a surprise, the attractiveness of USD rates appears diminished, and if the dollar index falls below 102, the psychological threshold of 100 could be within reach.

Sterling Struggles Amid Market Calm, Needs Fresh Catalyst for Revival

Despite the dust settling after the market turmoil at the start of the week, sterling continues to struggle against its major peers. GBP/USD is flirting near key moving average support levels on the daily chart, around $1.27, while GBP/EUR is edging closer to €1.16, primed for another 1% weekly decline. It's clear sterling needs a fresh positive catalyst to resume its climb from the first half of 2024.

Revised UK GDP data wasn’t such a catalyst. It turns out that 2022 was better than statisticians thought, as UK GDP jumped 4.8%, instead of the 4.3% previously estimated, according to annual revisions. The data suggest the economy was showing underlying resilience even as it began to be roiled by Russia’s invasion of Ukraine, which sent inflation in Britain surging to a peak of 11.1% in October 2022. The impact of the cost-of-living crisis later triggered a recession and slowed annual GDP growth to just 0.1% in 2023. However, the economy has bounced back more quickly than many forecasters had expected this year as the surge in inflation fades.

The Bank of England’s (BoE) interest rate cut, coupled with the fall in inflation, has reduced the pound’s real yield appeal. Additionally, speculative positioning was heavily stretched in favour of sterling bulls coming into the second half of the year. Hence, the bullish drivers of sterling strength have weakened of late, but we think a sustained improvement in global market risk appetite should act as a welcome relief for the UK currency alongside the brighter UK growth outlook.

Improved Market Sentiment Boosts European Equities and Stabilises EUR/USD

Market sentiment improved further on Wednesday, with European equities climbing higher and Bund yields recovering to pre-NFP levels. Bunds edged lower for a third day as investors continued to unwind haven buying, and the EUR/USD spot rate remained largely stable around Wednesday’s open rate of $1.083.

Bund yields are likely to continue trading in lower ranges as European Central Bank (ECB) and Federal Reserve (Fed) rate cuts are anticipated. In the Eurozone, the market’s assessment of recession risk remains elevated, as incoming data does not show a marked improvement. Yesterday’s macro data from Germany showed a sharp fall in exports, which was counteracted by better-than-expected industrial production growth in June. This suggests that while the export-oriented growth model is fundamentally struggling, there could still be a small cyclical improvement in the second half of the year.

With assistance from soothing comments by the Bank of Japan, the euro rallied against the safe haven currencies JPY and CHF by more than 1.4% but continues to trade lower compared to a week ago. Having rallied close to 2% over the past five days, EUR/GBP has eased from near three-month highs and is now below the £0.86 level. Money markets continue to trim ECB rate-cut bets, pricing in 68bps of easing by year-end compared to 71bps the day prior. Investors are more hesitant to price out Fed easing at the same pace, thus maintaining EUR/USD relatively supported for now.

With the domestic calendar empty, the only key risk event is the US initial jobless claims. We can expect volatility following the release of this report, as market participants will be looking for data to support or disprove the belief that the US labour market is slowing faster than the Fed expects, thereby justifying the current OIS curve pricing.