The Pound Sterling has rebounded against the Euro, supported by improved market sentiment, with the Pound to Euro (GBP/EUR) exchange rate at 1.1860 on Friday. We expect it could rise further, targeting an initial resistance at 1.1882 over the next day or two, provided global equity markets remain positive. The strong correlation between GBP/EUR and the U.S. S&P 500 index has been a key factor in the Pound's midweek recovery, driven by gains in the stock market.

The European Central Bank’s recent decision to cut interest rates had little impact on the Euro, as it was widely anticipated. In fact, the ECB's balanced guidance and updated forecasts have supported the Euro, as they did not signal an accelerated pace of rate cuts. Economists expect the ECB to continue reducing rates gradually, around once per quarter, providing a stable outlook for the Euro and limiting any further upside for the Pound to the 1.1882-1.19 range.

Looking ahead, central bank policy will take centre stage, with next week’s inflation report posing a key risk for the Pound. We see asymmetric risks for Sterling, with the currency likely to be more sensitive to weaker-than-expected inflation data. While markets anticipate the Bank of England will hold interest rates steady next Thursday, a downside surprise in inflation could raise expectations of future rate cuts, which would weigh on the Pound.

Unexpected Rise in Core Inflation

The US dollar index (DXY) surged to a one-week peak, and Treasury yields rebounded from two-year lows after the latest US inflation report. This report has increased expectations that the Federal Reserve (Fed) will opt for a 25-basis point rate cut instead of a 50-basis point cut next week.

The CPI report was the final major data release before the highly anticipated Fed meeting, during the blackout period. The headline rate decelerated for the fifth consecutive month to 2.5% in August, the lowest since February 2021. Moreover, the six-month annualised CPI measure fell below 2% for the first time since 2020, indicating significant progress on inflation. However, the core measure drew the most attention, as it slightly exceeded expectations, rising 0.3% month-on-month compared to the anticipated 0.2%. The increase in super core inflation is also notable, with prices in core services excluding housing reaching their highest level since April, suggesting that price pressures are intensifying beyond shelter. As a result, the likelihood of a quarter-point rate cut by the Fed next week rose to about 80% from 70% before the release. The probability of a larger 50-basis point cut has decreased, but it is still not entirely ruled out.

Despite the dollar’s downtrend since June, the DXY’s 200-week moving average, at 100.4, remains a crucial support level in the short term. If GBP/USD and EUR/USD fall below their psychologically significant $1.30 and $1.10 levels respectively, a short-term dollar recovery could gain momentum ahead of the Fed’s decision next Wednesday.

Pound Holds Above Key Level

The British pound briefly dipped to a three-week low against the US dollar yesterday after UK GDP showed no growth in July and US inflation data strengthened the dollar. GBP/USD is now down nearly 2% from its two-year high of $1.3266 recorded last month but remains above the critical $1.30 level for now, with central bank decisions approaching next week.

Seasonal trends are not favourable for sterling, as September has historically been the worst month of the year for GBP/USD since 2000. Currently down 0.6% month-to-date, the pair could end what has been the longest period without a 1% monthly decline since 2014. The pair has been weighed down by UK-US rate differentials, which have recently fallen from one-year highs. This is due to money markets increasing bets on Bank of England (BoE) easing this year, while expected Fed easing has slightly decreased following recent economic data. However, we still expect the BoE to remain the most hawkish among G3 central banks, which should support the pound into year-end.

The next key data point for these monetary policy bets will be UK inflation data, due a day before the BoE decision next Thursday. Any further signs of cooling services inflation could increase BoE easing bets for the remainder of 2024, currently standing at 50 basis points (two rate cuts). This would be a significant headwind for the pound, especially for GBP/USD if the Fed adopts a more cautious approach than markets currently expect.

Euro Weakens Ahead of ECB Decision

As mentioned in yesterday’s update, the euro started Wednesday’s session up by over 0.2% against the US dollar, buoyed by the perceived win of Kamala Harris in the first televised US presidential debate against Trump. However, the common currency later lost its gains following a hotter-than-expected US core CPI print. This data dashed hopes of a 50bps rate cut by the Fed next week, resulting in a dollar-positive outcome. In Europe, equities trended lower, reflecting both the spillover effects of disappointing US inflation data and cautious sentiment ahead of the ECB rate decision. Meanwhile, European bonds, particularly German Bunds, continued to see strong demand, with German two-year bond yields falling to their lowest level since March 2023 after seven consecutive sessions of gains.

The ECB rate decision later today is the highlight of this week’s domestic calendar. A 25-basis point cut is widely expected and fully priced in, but the market’s focus will shift to the ECB’s communication and staff forecasts. Signals regarding future rate cuts are unlikely to be firm, as the Governing Council is expected to maintain maximum flexibility. We see three main sources of potential euro weakness following today’s decision: (1) Current pricing offers attractive levels for long positions, with only 60bps priced in by year-end. This leaves ample room for risk premium, particularly with growth concerns that have yet to be fully acknowledged by the market or equity weakness likely in the coming months. (2) A shift in focus from inflation to growth concerns could accelerate the ECB’s rate-cutting cycle. (3) Given the strong correlations between USD and EUR rates, any dovish comments from ECB President Christine Lagarde could tilt risks towards euro weakness in the near term.

Ahead of the risk event, EUR/USD has moved towards the $1.10 support level, near the 35-day SMA. A break below could see the pair testing the 50-day SMA at $1.096. Additionally, market sentiment, measured by 25-delta risk reversals, has shifted from a bullish to a neutral stance.

Election Odds Shift, Dollar Declines

The initial presidential debate between former President Donald Trump and current Vice President Kamala Harris in Philadelphia has concluded. Many policy questions remain unresolved as both candidates tentatively agreed to another debate before 5th November. Interestingly, Taylor Swift’s endorsement of Kamala Harris, who is perceived to have slightly outperformed Trump in the debate, may have influenced voter intentions more than the debate itself. Markets seem to concur. Betting markets now show a slight preference for Harris (56-52%) over Trump (48-44%) in winning the election, leading to a decline in the dollar and US equities during the Asian trading session. Trump is currently viewed as more favourable for these assets due to his tax reduction policies and additional tariffs.

Government bond yields have continued to decline this week. The 2-year Treasury yield dropped to 3.57%, nearing its low from September 2022. Fed futures are leaning towards a 25 basis point cut next week, with the probability of a larger cut increasing slightly from 30% to 35% since yesterday. Today’s eagerly awaited CPI report could slightly adjust these probabilities. Inflation is expected to have decreased from 2.9% to 2.6% in August, with the core rate remaining at 3.2%. With no Fed commentary due to the blackout period, investors will interpret the data independently.

Bank of Japan officials maintain their hawkish stance, suggesting a potential rate hike before the end of the year. This anticipated policy normalisation, combined with US yields falling to 17-month lows, has pushed USD/JPY to a new 2024 low of 140.50¥. The Japanese yen is currently surging in FX markets, having appreciated against 98% of global currencies since the start of the second half of 2024. Looking ahead, risks for the yen are more balanced. Asset managers have turned net-bullish on the currency for the first time this year, and with 270 basis points of Fed cuts already priced into futures for the next 24 months, there is limited room for further dovish repricing. A gradual appreciation to below the 140¥ mark remains our baseline.

Pound Declines as Growth Stagnates

The UK economy remained stagnant in July, mirroring the previous month’s performance and falling short of market expectations across all key sectors. Services output increased by 0.1%, following a 0.1% decline in June, but a 0.8% drop in production output, driven by weakness in manufacturing, resulted in no overall growth for the month. Construction output also contracted by 0.4%, after a 0.5% rise in June. Over the three months to July, UK GDP grew by 0.5%, with widespread growth in the services sector, though it still missed forecasts and is tracking the slowest quarterly pace this year.

As UK markets open, we expect rates to trend lower as traders react to the disappointing data, with some bets on rate cuts potentially added into the OIS curve. However, we do not believe this significantly changes the Bank of England’s near-term outlook. We expect the BoE to remain the most hawkish among G3 central banks, refraining from cutting policy rates in next week’s decision, where the probability of a rate cut has stayed around 20% over the past month.

Despite the weaker data, the pound was initially unaffected, buoyed by a midnight boost from US election polls showing Kamala Harris rising to 56% in prediction markets, but eventually lost the early gains. We anticipate a muted reaction from the pound ahead of the US CPI release later today. However, once that hurdle is cleared, we foresee some weakening of the pound due to the disappointing growth outlook.

Euro Gains from US Presidential Debate

The euro received an early morning boost following the US presidential debate, having previously fallen to a 3-week low of $1.103 in the prior session, as investors grew increasingly cautious ahead of key risk events this week. European equities pulled back on Tuesday, reducing the week-to-date gains by three-quarters, while bonds remained in demand. The two-year Bund yield fell to a more than seven-month low of 2.14%, underperforming US Treasuries.

On the domestic macro front, there was little to move markets, as the final German CPI for August matched preliminary readings at 1.9% year-on-year. More notably, VW ended its three-decade-old German jobs guarantee, which will effectively cease by mid-2024, in an effort to cut costs. This follows last week’s announcement of potential plant closures in Germany, the first such move in 87 years. The end of job security commitments highlights how far Europe’s largest economy has fallen behind in terms of competitiveness.

The domestic calendar remains quiet today, with the main macro focus being tomorrow’s ECB rate decision. As traders hold off ahead of the US core CPI release later today, we expect subdued spot volatility until the event. Given that the Fed has unofficially signalled a rate cut in September and overnight volatility is trading in line with recent levels, we do not anticipate significant market movements outside of the usual post-data fluctuations.

British Pound Eases From 5-Month High as Markets Await Key Data

The British pound is gradually pulling back from its five-month high of $1.3270, which it hit against the US dollar at the end of August. Global sentiment has improved following Friday’s weaker-than-expected US job report, which sent ripples through financial markets. However, Sterling has yet to gain any upward momentum this week. Investors are holding back as they await critical economic data ahead of the Federal Reserve (Fed) and Bank of England (BoE) decisions later this month, with caution prevailing around pushing the pound above the $1.31 level.

Today's UK employment figures closely matched expectations, providing little incentive for significant market repricing. Unemployment dropped by 73.6k, lowering the rate to 4.1% in the three months to July. Meanwhile, average earnings growth moderated more than anticipated, falling from 4.6% to 4.0%, with earnings excluding bonuses slowing from 5.4% to 5.1%. Overall, the data does not appear to support any imminent policy easing from the Bank of England, with the probability of a rate cut in September currently around 22%. Markets are pricing in just one rate cut, which we believe is too hawkish. However, declining inflation and wage growth toward year-end could pave the way for an additional rate cut.

With labour market reports from both the US and UK now behind us, investor focus is shifting to upcoming GDP and inflation data. Tomorrow’s release of UK GDP, goods trade, industrial production, and manufacturing production figures will be followed by US inflation data, which could determine whether the Fed opts for a 25 or 50 basis point rate cut next week. Implied one-week volatility rates for GBP/USD and GBP/EUR have recently settled at their 2024 averages of around 6.4% and 4.4%, respectively. As global equities enter a seasonally weaker phase and with key rate decisions and the US election approaching, investors may be underestimating the potential risks in foreign exchange markets.

Global Equities Find Strength Amid Hopes for Central Bank Intervention

Global equity markets began the week on a stronger note, with dip-buying behaviour persisting as investors remain hopeful that central banks will step in before growth concerns take hold. Last week, the Bank of Canada implemented its third rate cut of the year, while the European Central Bank (ECB) is set to make its second cut on Thursday.

The US dollar followed bond yields higher in anticipation of tonight's presidential debates and Wednesday's critical CPI report. The Greenback has been on a steady decline, dropping about 4% since early July and turning negative for the year. Falling bond yields and heightened expectations of Federal Reserve easing have weighed on the appeal of the dollar, reinforcing a medium-term negative outlook. In the short term, further below-consensus economic data would be needed to push pairs like EUR/USD and GBP/USD higher. Inflation, expected to fall from 2.9% to 2.6% in August, is unlikely to support the dollar this week. With markets already factoring in a 25-basis-point rate cut, a downside surprise in inflation would likely have a greater market impact than an unexpected upside.

EUR/USD Faces Key Test Ahead of ECB Decision and US Election Debate

EUR/USD is holding near the $1.104 support level, but this support may soon be challenged. With few domestic macroeconomic events scheduled before Thursday's European Central Bank (ECB) rate decision, tonight's US election debate could provide the first major catalyst of the week. While one-week risk reversals narrowed significantly during yesterday’s session, they remain slightly tilted in favour of euro calls, indicating a marginal bias toward further euro strength.