Pound Sterling's Strength: On Track for a Third Weekly Rise Against USD and EUR

The British pound is heading for its third consecutive weekly gain against both the US dollar and the euro, reaching over two-year highs this week. Growth and yield differentials have favoured sterling recently, with increased risk appetite further boosting its performance.

The primary bullish factor for GBP this year has been interest rate and yield differentials, as the Bank of England (BoE) has adopted a more cautious stance on cutting interest rates compared to its peers. Market expectations reflect this, with fewer rate cuts anticipated in the coming years. Currently, only 40 basis points of BoE easing are priced in before year-end. However, there is a downside risk to the pound, as the BoE may cut rates at both its November and December meetings, particularly if services inflation decreases.

Growth divergence is also at play, especially in the GBP/EUR pair. Despite some underwhelming PMI survey results in the UK, overall private sector activity has expanded for eleven consecutive months, reflecting a healthier UK economy compared to Europe. Political challenges in Europe further weaken the euro, giving the pound an additional advantage.

For GBP/EUR, holding above the €1.20 level is crucial for establishing a new trading range. The pair has already broken above its 200-month moving average, suggesting it could achieve its strongest Q3 performance since 2014. Similarly, GBP/USD is on course for its best Q3 since 2013, and its fifth-best on record, defying typical seasonal patterns.

Dollar Downtrend Pauses Amid Mixed US Data and Uncertainty

The recent decline in the US dollar has slowed this week, supported by mixed economic data. Revised GDP figures revealed stronger-than-expected economic growth in the second quarter, while durable goods orders remained flat. Additionally, US unemployment claims dropped by 4,000 to 218,000, marking a new 4-month low and highlighting the labor market's resilience. However, earlier data showed a worsening labour market differential, suggesting a higher unemployment rate in the upcoming September jobs report, which could pave the way for another significant Federal Reserve rate cut later this year.

In the short term, monetary policy dynamics continue to influence the currency markets, signalling further potential dollar weakness. A wave of global stimulus measures boosting risk appetite may also weigh on the safe-haven dollar. However, the upcoming US election in November introduces uncertainty into this bearish outlook. A Republican victory, particularly a clean sweep, is seen as the most USD-positive scenario.

Concerns Rise Over Potential Acceleration of ECB Rate Cuts Amid Economic Struggles

Markets are growing increasingly worried that the European Central Bank (ECB) may speed up its rate-cutting efforts, possibly shifting from its usual quarterly pace at the upcoming October meeting due to deteriorating economic conditions. Although Germany's GfK consumer climate indicator showed slight improvement, persistent declines in consumer sentiment and a rise in savings signal continued obstacles to the region’s recovery. The likelihood of a rate cut at the October meeting has risen to over 60%, up from 40% earlier in the week.

US Dollar Index Sees Biggest Daily Rise Since June, But Short-Term Outlook Remains Bearish

On Wednesday, the US dollar index experienced its largest daily increase since June, driven by the 10-year US Treasury yield rising above 3.8%, the highest in three weeks. Despite this, the narrative of a soft economic landing persists, and markets continue to anticipate more aggressive rate cuts by the Federal Reserve (Fed), suggesting that the dollar may face downward pressure in the short term.

Attention now shifts to today's US GDP data and weekly unemployment claims. Tomorrow, the focus will be on the core PCE deflator, the Fed's preferred inflation gauge. A low reading, such as 0.1% month-over-month, could further weaken the dollar.

Pound Outlook Bullish Amid Strong Growth and Yield Differentials

The pound continues to benefit from favourable growth and yield differentials, with a short-term target of $1.35 for GBP/USD. Its high sensitivity to risk supports its strength as long as global risk appetite remains positive, bolstered by China’s recent stimulus measures. However, with the US election just over a month away, demand for the safe-haven US dollar could rise due to uncertainty over the outcome.

Against the euro, sterling is set for its seventh straight monthly gain, marking its longest winning streak against the common currency. As the quarter ends this week, some volatility in foreign exchange markets could emerge as portfolio managers rebalance their positions.

European Equities Face Continued Losses Amid Market Fatigue

European equities fell for the second straight day, with the Stoxx50 struggling to break through the 4950 level. A month ago, we noted the risk of market fatigue, suggesting that 5000 could act as a ceiling for gains, a scenario that has now played out. Despite a 7% rebound since the August low, European equities remain in a broad downtrend since the May peak, driven by weakening macroeconomic fundamentals that have made euro-denominated assets less appealing. Looking ahead, the market is entering a period that has historically seen significant downturns, potentially posing challenges as we head into Q4.

Australian Dollar Weakens Following RBA's Interest Rate Outlook

The Australian Dollar has fallen against most of its currency counterparts after the Reserve Bank of Australia (RBA) signalled a potential shift toward its first interest rate cut. Although the RBA left interest rates unchanged at 4.35%, it acknowledged that the economic outlook appeared "slightly softer" than anticipated at its August meeting.

This dovish stance is reflected in exchange rates, with the Pound to Australian Dollar rising to 1.9540, and the Euro to Australian Dollar reaching 1.6284. Meanwhile, the Australian Dollar has declined against the U.S. Dollar, trading at 0.6828.

For the first time since March, the RBA did not discuss a potential rate hike at its latest meeting. However, it reiterated that no rate cuts are expected "in the near term." The Bank expressed concerns that consumption growth could remain sluggish for an extended period, reducing inflationary pressures despite forecasts for economic growth to return to normal levels. Nonetheless, the RBA remains cautious about inflation, noting that disinflation has stalled, and stressed the need to stay alert to any potential inflationary risks.

While the RBA’s decision suggests there is no immediate rush to exit tight monetary policy, the initial steps toward easing have been made, contributing to a softer Australian Dollar. Currency watchers should also monitor developments in China, where newly announced stimulus packages may strengthen Australia’s primary trading partner, providing longer-term support for the Aussie.

AUD/USD Breaking Key Resistance

The AUD/USD has seen a shift toward positive short-term momentum after closing above the key resistance level of 0.6825, with crucial moving average indicators now trending upward. Longer-term resistance is expected just above the 0.7000 mark.

The AUD/USD has reached a 14-month high, while the AUD/EUR is now trading at a two-month high.

Consumer Confidence Decline Fuels Fed Easing Expectations

Adding to the pressure on the U.S. dollar and expectations for Federal Reserve easing was the release of the Conference Board's consumer surveys on Tuesday. The data revealed that consumer confidence fell significantly below forecasts, coming in at 98.7 compared to the anticipated 104 for the month. Attention also focused on the labour market differential metric, which tracks the gap between the percentage of consumers who believe jobs are plentiful and those who think jobs are hard to find. This gap continued to widen, suggesting a higher U.S. unemployment rate in the September jobs report, due next Friday.

The Federal Reserve had projected the unemployment rate to rise to 4.4% by year-end. If it exceeds this level, as the data indicates, the market may be justified in anticipating another 50 basis point rate cut during the Fed's November or December meetings.

Sterling's Bullish Momentum Continues in Q3

The strong performance of the British pound from the first half of the year has extended into the third quarter, supported by positive UK economic data, including this week's PMI reports. With expected growth differentials influencing G10 currencies, the pound has benefited from its attractive yield appeal. Additionally, heightened risk appetite has further boosted sterling. As a result, GBP/USD has risen above $1.34 and GBP/EUR above €1.20, both reaching over two-year highs.

This doesn’t rule out GBP/USD extending towards $1.35, but the upward momentum may begin to fade sooner, especially if we see increased FX volatility due to month- and quarter-end flows this week.

Euro Rebounds on China Stimulus, but Economic and Political Risks Loom

The euro bounced back after briefly dipping below $1.11 at the start of the week, lifted by improved global sentiment following China’s announcement of an economic stimulus plan aimed at meeting year-end growth targets. European stocks rallied, with the French CAC 40 climbing over 1% to a three-week high, driven by gains in the luxury sector, which stands to benefit from China’s recovery efforts. However, European bonds faced selling pressure amid this risk-on environment.

Despite the market’s positive reaction, underlying concerns about the Eurozone economy persist. Germany’s business outlook has deteriorated, with the Ifo institute’s expectations index falling to 86.3 in September, its lowest since February, while the current conditions index dropped to a four-year low of 84.4. These disappointing figures, along with weak flash PMIs and declining business and consumer sentiment across the Eurozone, have fuelled expectations of a European Central Bank (ECB) rate cut in October. The probability of a cut, reflected in the OIS curve, has risen from 40% to 63% this week, despite opposition from some ECB officials. While ECB’s Muller acknowledged the potential for a rate cut, he warned that there may not be enough data to support a definitive decision by next month.

Adding to the euro’s challenges is political uncertainty in France. The 10-year OAT-Bund yield spread has widened to 78 basis points, the highest since August, as investors grow concerned over France’s delayed budget and the threat of a no-confidence vote. Prime Minister Barnier’s government faces an October 1 deadline to submit the budget for parliamentary debate, with potential for further political instability. Additionally, Fitch and Moody’s are set to review France’s fiscal health on October 11 and 25, following an earlier downgrade by S&P Global. These factors are contributing to a higher risk premium for French debt and could weigh on the euro in the weeks ahead.