Smooth Sailing After the Storm?

In just three weeks, approximately $6.4 trillion has been wiped from global stock markets due to rising fears of a US recession, disappointing AI-driven earnings from Big Tech, and a significant unwind of carry trades, leading to a more than 10% appreciation of the Japanese yen. The US dollar showed mixed performance, benefiting from safe-haven flows yet weighed down by concerns over weaker growth and high-yield appeal.

Deutsche Bank’s FX Volatility Indicator shows currency volatility has surged to levels last seen in October 2023, exceeding its 5-year average. Despite this, broader financial markets are showing signs of stabilizing today. Japanese equities have rebounded, leading gains in Asia as they recover some of the 12% losses from Monday’s global rout. Additionally, Euro Stoxx 50 futures and US equity futures have advanced, while Treasury yields have fallen. 

In the Treasury market, heightened demand pushed two-year yields, which are sensitive to monetary policy, below those of the 10-year note for the first time in two years. This briefly caused the US yield curve to turn positive for the first time since July 2022, after being inverted for a record duration. Typically, the yield curve steepens back above zero around the onset of an economic slowdown. However, both yields and equities recouped some losses yesterday afternoon after the US ISM services PMI exceeded expectations, driven by a rebound in new orders and the first rise in employment in six months.

Consequently, an off-cycle rate cut by the Federal Reserve appears even less likely. It seems more prudent for policymakers to wait until the September meeting to implement a 25 or even 50 basis point easing, depending on incoming data. Nonetheless, market nervousness might keep the US dollar strong, particularly against emerging market currencies.

Pound Steadies Alongside Equities

Thanks to stabilising equity markets and improving risk sentiment following Monday’s turmoil, the British pound has maintained its grip on the $1.27 support level against the US dollar, staying above key moving averages. Further bolstering sterling, UK retail sales rose 0.3% on a like-for-like basis in July compared to a year ago, reversing a 0.5% decline in June and aligning with market expectations.

This return to growth was largely driven by consumer purchases of clothing and beauty products in preparation for the holidays, as the late arrival of British sunshine boosted spending. Additionally, the final services PMI for July was revised slightly higher, marking the ninth consecutive month of expansion in the UK services sector. These recent improvements in economic activity coincided with the Bank of England beginning to cut interest rates, raising expectations for stronger underlying spending growth in the second half of the year.

While this should support the British pound in the longer term, rate differentials suggest sterling might be overstretched, especially against the euro. As a result, it's not surprising to see GBP/EUR stuck below €1.17, with the pair having dropped over 2% in just a few trading sessions.

Euro has finally found support

The euro has found support from a softer US outlook, rallying to an 8-month high amid safe-haven and positioning unwind flows. Although the pair briefly surpassed the $1.10 threshold, it quickly lost momentum following a better-than-expected US ISM report. This rally has reduced the euro’s year-to-date losses to approximately 0.7%, making it the second-best performer among G10 currencies, just behind the GBP. If the US soft landing scenario faces further skepticism, the euro could climb higher. However, the rally is unlikely to be sustained as weaker global growth does not favour the pro-cyclical euro.

The global stock correction has triggered a rush into Treasuries and European bonds. German 2-year yields dropped almost 20bps in early Monday trading, marking the most aggressive European bond rally since the French snap election announcement. The German front end is trading as though the European Central Bank is poised to cut interest rates imminently. At one point, traders were betting on as many as 42bps of ECB cuts in September and 94bps of cuts by year-end. Rate cut expectations have since stabilized to Friday’s levels, with 26bps anticipated for September 2024 and 77bps by December 2024. The BTP-bund and OAT-bund spreads widened by 7bps and 4bps, respectively, as fears of a global recession grow.

Elsewhere, the euro remains under pressure from safe-haven flows. EUR/CHF depreciated for the sixth consecutive day amid risk-off sentiment, pushing the spot rate near 2024 lows. The euro also posted another single-digit loss against the Japanese yen due to the continued unwind of short yen positions. The options market shows clear signs of heightened market stress. All G10 euro crosses exhibit an inverted implied volatility term structure, with implied volatility for tenures up to 4 months exceeding those on longer tenures. EUR/JPY implied volatility structure is now entirely in backwardation. EUR/USD 1-week risk reversal saw the sharpest single-day bullish repricing in two years last Friday, with the skew currently at 0.373 vol in favour of calls.

Last week, GBP's high sensitivity to risk asset performance was evident despite a relatively hawkish first rate cut by the Bank of England (BoE). GBP/USD is struggling to maintain its $1.27 support level, while GBP/EUR has fallen below €1.17 at interbank for the first time since May. However, the Japanese yen is the real standout, with GBP/JPY plummeting 13% since mid-July, including a 10% drop in just the past week, erasing all its year-to-date gains within weeks.

Markets had priced in a 60% chance of a BoE rate cut to 5%, and the BoE’s Monetary Policy Committee (MPC) voted 5-4 in favour of the cut last Thursday. Although a hawkish tone initially limited GBP's losses, gilt yields dropped to fresh one-year lows, and markets began anticipating more rate cuts by the BoE this year.

The EUR surged past the $1.09 mark on Monday as weak US NFPs and a higher US unemployment rate shook the markets. Meanwhile, EUR/JPY saw its worst monthly decline in eight years (-5.8%), and EUR/GBP fell for the fifth consecutive month in July, the worst streak since January 2020. Despite this poor performance, the EUR rallied to a one-month high by the end of the week, a delayed reaction to the BoE’s hawkish decision last Thursday.

This week’s economic calendar is light, with key items including final PMIs, Sentix Investor Confidence, German factory orders, and European retail sales. As we enter a seasonally quiet period for both data and ECB speakers, this could be beneficial for the EUR. The EUR has shown a strong positive correlation with a decrease in realised FX volatility, which may help support it during this lull in activity.

As anticipated earlier this week, the Bank of England (BoE) implemented a slightly hawkish rate cut yesterday, leading to a limited negative reaction from the pound. The GBP/USD pair fell nearly 0.8%, reaching $1.2750 just before the announcement, its lowest point in over three weeks. However, it recovered during the press conference, climbing back above $1.28, almost to its starting level for the day.

The markets had priced in a 60% probability of a 25 basis point rate cut to 5%, and the BoE’s Monetary Policy Committee (MPC) voted 5-4 in favour of the cut. For the MPC members who shifted from holding to cutting, the minutes indicated that the decision was “finely balanced.” This suggests to traders that policymakers might adopt a cut-and-hold approach, similar to the ECB’s strategy. We don't anticipate another cut next month; currently, money markets are pricing the next cut for November, with a 50% chance of a third in December. Gilt yields fell to their lowest in over a year, but the pound remained resilient, bolstered by hawkish comments in the press conference warning of potential inflation risks. Inflation is expected to rise to 2.7% by year-end before decreasing from 2025 through 2027. Meanwhile, the UK's growth forecast has been upgraded to 1.25% for this year, more than double the BoE's May projection.

Consequently, the central bank will proceed cautiously with further cuts, focusing on reducing restrictiveness rather than easing. This approach explains the pound's limited reaction. Although the bullish positioning of GBP appears concerning in isolation, we remain cautious about turning too bearish on the pound, given that the BoE is not alone in cutting rates and the UK's economic outlook is improving.

The Bank of Japan raised interest rates, while Fed Chair Jerome Powell suggested the possibility of rate cuts in September. Despite these developments, the British pound remained stable as investors are cautious ahead of the Bank of England's decision. Unlike previous well-anticipated meetings in London, today's decision presents uncertainty as economists and markets are divided on whether the dovish members will succeed in pushing through a rate cut.

The main argument for easing policy is the significantly higher real rate (policy rate minus inflation) in the UK compared to the United States and Eurozone. Although headline inflation has decreased to 2.1%, the benchmark rate remains at 5.25%. On the other hand, hawks within the Monetary Policy Council (MPC) argue that the economy is robust, having grown by 0.7% in Q1. Additionally, services, rent, and wage inflation remain high and persistent, with leading indicators suggesting a slight reacceleration of inflation. Nonetheless, markets seem to expect the Bank of England to initiate a cutting cycle, as indicated by the 2-year yield falling to its lowest level since March 2023, at 3.8%.

The GBP/USD has been flat this week but could see increased volatility today with the BoE decision and tomorrow with the US labor market report. The current intra-week range of $1.2800 to $1.2880 is likely to be surpassed due to these significant risk events.