The risk-off sentiment in global financial markets this week has impacted Bank of England (BoE) policy expectations. The likelihood of a BoE rate cut in August has risen above 50%, pushing the 2-year gilt yield below 4%, reaching a new one-year low. Consequently, the pound is on track for its second consecutive weekly loss against the US dollar, hovering near its critical 200-week moving average around $1.2850.

Similar to the dollar, the pound's largest weekly declines have been against safe-haven currencies like the Swiss franc and Japanese yen, with the latter dropping almost 3% this week—its worst performance since the UK mini-budget crisis in late 2022. GBP/EUR is also set for a second weekly decline, retreating further from nearly two-year highs above €1.19. Given the pound's vulnerability against these major currencies, we believe markets might be underestimating the chances of UK rate cuts this year. Whether the first move happens in August or September remains uncertain, and with 1-week GBP/USD implied volatility at a one-month high, markets are bracing for a tense BoE meeting next week.

However, if the BoE issues a hawkish cut or maintains rates, emphasizing the persistent inflation risks, we could see GBP/USD and GBP/EUR rebound towards $1.30 and €1.20, respectively. This outcome, though, will also depend on broader global market conditions, as evidenced this week.

On Wednesday, the US dollar index experienced its largest daily drop in five sessions, primarily due to the ongoing strength of the Japanese yen. This surge in the yen is attributed to unwinding carry trades, safe haven flows, and increasing expectations of a rate hike in Japan following a significant rebound in Japanese private sector activity.

The yen appreciated to over 153 per dollar, its highest level in more than two months, compelling short-sellers to exit their positions. Since mid-July, the yen has strengthened by over 5% against the dollar, a movement initially sparked by suspected government intervention. Meanwhile, market risk sentiment deteriorated further as the tech-heavy Nasdaq 100 fell, prompted by a series of disappointing earnings from major European companies, which increased demand for safe havens like the yen, Swiss franc, and gold. In the US, the composite PMI rose to 55.0 in July from 54.8 in June, the highest since April 2022, indicating continuous growth over the past 18 months, with the service sector outperforming manufacturing for the fourth consecutive month. Despite this growth, employment slowed and business confidence declined due to rising political uncertainty.

The yen's rally and its potential for a significant reversal hinge on upcoming monetary policy decisions by the Bank of Japan and the Federal Reserve on July 31. While no changes to US interest rates are expected, the 2-year Treasury yield fell below 4.40% for the first time since February after New York Fed President Bill Dudley indicated that economic conditions might justify a rate cut. The first rate cut is still anticipated in September, in line with market expectations. In contrast, the likelihood of a rate hike in Japan has surged from 45% to over 80% this week, maintaining strong demand for the yen.

Yesterday was a quiet day in the FX markets, with no significant economic data or political events. The standout movement was the strength of the Japanese yen. The GBP/JPY and EUR/JPY pairs both dropped by around 1%, and the USD/JPY pair fell by 0.7%. After reaching multi-decade highs just a few weeks ago, the yen is benefiting from the unwinding of carry trades and speculation that the Bank of Japan will raise interest rates a couple of times this year.

Turning to central banks, investors are keenly anticipating the Bank of Canada's (BoC) interest rate decision today. It is expected to implement a consecutive 25 basis point cut, positioning it as the most dovish among advanced central banks. The BoC, like many others, is operating in a data-dependent mode. Factors such as subdued economic growth, easing employment pressures, and lower inflation are the key criteria for consecutive rate cuts, but the decision may not be straightforward. On one hand, a lower-than-expected headline inflation and expectations of further favorable news in the near term support more cuts. On the other hand, the disinflation process is no longer broadening, and measures of services and core inflation are showing signs of persistence.

The anticipated rate cut in Q3 has been priced in for some time, and speculative positioning remains heavily bearish on the CAD, indicating crowded trades. Unless there is a significant slowdown in economic momentum or the Governing Council provides additional guidance for near-term easing beyond current market expectations, the impact on the CAD should be limited.

Parallel to GBP/USD reaching a new 1-year high above $1.30 last week, bullish bets on the British currency surged to a record high. Although sterling has experienced a slight correction, the heavy speculative positioning in GBP ahead of the Bank of England’s (BoE) rate decision next week leaves the currency vulnerable.

According to Commodity Futures Trading Commission data, non-commercial traders, including hedge funds and asset managers, increased their net long position on the pound to an all-time high last week. This positioning reflects optimism about the UK’s better-than-expected economic performance this year, relative political stability with a majority Labour government, and the currency's attractiveness to carry traders due to the BoE delaying interest rate cuts. The carry trades, based on the pound’s high yields compared to other currencies, may unwind as uncertain monetary policy and the upcoming US presidential election approach. FX volatility has been low, supporting carry trade strategies, but if investor anxiety about price swings grows, high-yielding currencies sensitive to risk sentiment, like GBP, could suffer. Indeed, with upcoming Fed and BoE meetings, the 2-week implied volatility gauge has risen to its highest in a month.

Additionally, money markets see a 40% chance of a BoE quarter-point interest rate cut in August, giving bullish GBP traders another reason to be cautious. A surprise rate cut from the BoE could sharply weaken sterling. The 200-week moving average at $1.2850 is the first key support level to watch.