Euro Gains on Soft US Labour Data, While European Stocks Decline Amid Global Rout

The euro strengthened by over 0.3% on Wednesday, reaching $1.1085 against the US dollar after a weak US labour market report, reversing its losses for the week. In contrast, European stocks fell, with the STOXX 50 dropping over 1% as part of a global stock market downturn. Bonds rallied across markets, following similar moves in US Treasuries, while the front-end yield spread between Germany and the US narrowed to below 150bps, the smallest margin since May 2023.

In the Eurozone, domestic market activity was quiet, overshadowed by US developments. The Eurozone's August services PMI was revised down to 52.9 from 53.3, marking the seventh consecutive month of expansion, with the sharpest growth in three months. This growth was mainly driven by France, likely boosted by preparations for the upcoming Olympic Games.

Meanwhile, ahead of the September 12 ECB rate-setting meeting, several ECB officials shared their perspectives before entering a quiet period. Policymakers are largely expected to cut borrowing costs again following a significant reduction in June. ECB’s Kazaks hinted at a potential rate cut in the upcoming meeting, echoing other officials’ support for further cuts after no action was taken in July. The case for another cut has been supported by inflation falling to its lowest level since mid-2021, although some policymakers remain cautious, emphasizing that inflationary pressures are not fully resolved.

In the FX volatility market, attention is focused on the upcoming US Non-Farm Payrolls (NFP) report. A slight weakness in the dollar is expected to persist, especially if the US services ISM underperforms. EUR/USD one-week implied volatility rose to 7.5%, about 150bps above realized volatility, hitting a two-month high.

US Dollar Slides After Weak Labour Data, Focus Shifts to Upcoming Non-Farm Payrolls

After a strong start to the week, the US dollar weakened following softer-than-expected labour market data. Investors are now closely watching Friday's non-farm payrolls (NFP) report. Markets were already rattled by Tuesday's disappointing manufacturing PMI and a sharp drop in job openings for July, released on Wednesday.

Futures markets now predict a 45% chance of the Federal Reserve cutting interest rates by 50 basis points at its September meeting. Bond yields continued their two-week decline, and for the first time since 2022, the yield curve (2-year vs. 10-year) un-inverted. The US dollar dropped against all G10 currencies in yesterday's trading.

Job openings fell from 7.91 million to 7.67 million, the lowest level since early 2021. According to the Bureau of Labour Statistics, a key Fed metric—vacancies per unemployed worker—reached a three-year low. The decline was mainly driven by reductions in vacancies in the government, healthcare, and trade & transportation sectors. Additionally, the number of people quitting jobs and those finding new ones fell below pre-pandemic levels, standing at 3.28 million and 5.52 million, respectively.

Survey data from the Conference Board, including the labour market ratio (jobs plentiful vs. jobs hard to get), suggests further softening next month. The same is true for Tuesday’s PMI, with the new order vs. inventory indicator pointing to continued challenges in manufacturing. Friday’s jobs report will be crucial in determining whether the Fed will opt for a 25 basis point cut instead of a larger 50bp reduction and could either restore confidence in the dollar or lead to further weakness if job growth disappoints.

Canadian Dollar Strengthens Despite Dovish Bank of Canada Rate Cut

The Canadian dollar edged toward the low CAD/$1.35 range against the US dollar, despite the Bank of Canada’s dovish policy decision. Canadian bonds outperformed US Treasuries, with the 10-year yield trading about 2 basis points higher relative to the US 10-year, which remained largely unaffected by the BoC’s decision.

The Bank of Canada cut its policy rate by 25 basis points, lowering the overnight lending rate to 4.25%, as expected by the market. The central bank pointed to growing economic concerns, with inflation nearing the 2% target. Preliminary data suggests Q3 growth could fall short of the Bank's July projections, while the labor market remains stagnant, with unemployment steady at 6.4%. This opens the door for potential further rate cuts. Governor Macklem also highlighted that persistent price pressures in the housing market and certain service sectors continue to drive inflation.

Despite the rate cut, the Canadian dollar remains one of the more vulnerable G10 currencies, as yield differentials diminish its attractiveness. The BoC has already implemented three rate cuts this year and is expected to continue easing, while the extent of the Federal Reserve’s future rate cuts remains uncertain. Currently, overnight index swaps are pricing in an additional 58 basis points of cuts by the BoC by year-end, compared to 100 basis points anticipated from the Fed.

Market Sentiment Shifts as Global Risk Aversion Rises; US Dollar Attempts Recovery Amid Nvidia's Continued Decline

Global risk aversion has gripped market sentiment, leading to a recovery attempt by the US dollar while Nvidia extends its two-week decline to 15%. The S&P 500, a key benchmark for US equities, dropped by more than 2% in yesterday’s session, marking its worst performance since the August 5th selloff. Investors have been increasingly reallocating capital to safe havens since early last week, driven by concerns over upcoming US macroeconomic data that could influence the Federal Reserve's future decisions.

The week began on a negative note, with weaker-than-expected Chinese PMI data setting a cautious tone for global markets. The US manufacturing PMI that followed did little to alleviate these concerns, despite an improvement for the first time in five months. The index registered a reading of 47.2, still below the 50-point threshold that separates expansion from contraction. Although the employment sub-index rose from 41.7 to 43.6, it remained in contraction territory for the third consecutive month. A cautious outlook over the next 3-4 months is justified as the key leading indicator—the ratio between new orders and inventories—continued to decline.

On a more positive note, the Economic Optimism Index reached its highest level since April 2023, reflecting an improved personal financial outlook among households. While this data isn't directly market-moving, the ongoing ambiguity in economic indicators is supporting the US dollar. Investors may remain cautious throughout the week as they await the significant US jobs report due on Friday.

The US dollar is likely to stay strong this week, buoyed by expectations of a rebound in job growth. However, market reactions could hinge on the unemployment rate. A slight 10 basis point increase might unsettle markets and increase the likelihood of a 50-basis point rate cut from the Fed in September. In the meantime, markets will look for further direction from the July US job openings data set to be released tomorrow and the ISM services report due on Thursday.

British Pound Trends Lower Amid Volatile Trading, Faces Pressure from Global Sentiment

The British pound continued its downward trend in yesterday’s session but remains within its upper short-term trading range. In August, the realized volatility of GBP/USD surged to 4.7%, as the currency pair fluctuated between $1.2660 and $1.3260 over just 13 trading days. Since peaking last month, the pound has declined by about 1%. Although August is typically the pound's weakest month historically, this seasonal pattern did not emerge this year. However, the weak outlook for equity markets as Q3 ends could put additional pressure on the pound.

With no significant domestic catalysts this week, global sentiment will likely determine the direction of the pound. Fortunately, yesterday’s bond sale by the new Labour government did not unsettle markets. The British government attracted over £110 billion in orders for the bond auction, matching a record set in June for the highest demand relative to the auction size. For the first time in a while, political developments are not seen as a negative factor for the pound.

Euro Struggles Amid Rebounding Dollar and Weak Equity Markets

The euro has been hit hard by the rebounding US dollar and weaker equity markets, after gaining approximately 4.5% since the start of July. The initial rise was largely driven by expectations of Federal Reserve easing and a potential slowdown in the US economy. However, these assumptions have been challenged as the US economy outperformed in the second quarter of 2024.

Across the Atlantic, optimism has waned. German sentiment indicators turned negative in July and August, and inflation in Europe’s largest economy has dropped below the 2% target. This has resolved the debate over whether the European Central Bank will ease policy at its September meeting. Our cautious stance on the euro around the $1.12 level has proven accurate, as key indicators, including the real rate differential, suggest the currency pair will remain near its current rate of $1.1050. This is still above the 2-year average of $1.07 and this year’s mean of $1.08. Currently, EUR/USD is trading in the upper half of its 3-, 6-, and 12-month ranges.

With European macroeconomic news likely to stay in the background, any further increase in the exchange rate would likely depend on rising recession risks in the US, as there is limited room for additional Fed easing in 2024 or early 2025.

China’s Economic Struggles Persist

The cyclical segment of China’s economy remains under pressure due to fiscal limitations, weak domestic demand, and anticipated higher tariffs. Loan growth hit a record low in July, paralleling the unprecedented drop in Chinese bond yields across the curve. August didn’t fare any better, with the official composite PMI falling to its lowest point since December 2022. The manufacturing index stayed in contraction for the fourth month in a row, with all sub-components dipping below the 50 mark last month. This phenomenon has only occurred 12 times since 2005, all post-pandemic. The week’s first data release came from China, shifting focus to the US PMI for manufacturing, which will influence FX markets.

Seasonal Factors Could Impact Sterling

Sterling started September positively, bolstered by the final UK manufacturing PMI for August, which showed UK factory activity growing at the fastest rate in over two years. This marked the fourth consecutive month of expansion, suggesting a continued economic recovery in the UK for Q3.

This positive result starkly contrasted with the declining manufacturing activity across Europe. The Eurozone’s manufacturing PMI confirmed the sector remained in contraction in August, dragged down by Germany and France. The UK’s better-than-expected economic data, along with cautious comments from Bank of England (BoE) Governor Bailey on further rate cuts, have reduced expectations for UK rate cuts. Markets are now pricing in just 40 basis points of rate cuts from the BoE by year-end, compared to 60bps from the ECB. Consequently, the EUR/GBP 2-year swap rate gap has widened to its largest since February, favouring sterling. As a result, GBP/EUR remains strong just under €1.19, over three cents above its 5-year average.

However, after three consecutive weekly gains, GBP/EUR might lose momentum. Seasonal trends are negative for sterling, as September has historically been the worst month of the year for the pair since 2000. A significant decline would require a substantial increase in BoE easing expectations, making next week’s UK labour market data and the following week’s inflation data critical.

Political Uncertainty Rises in Europe

After climbing to a one-year high above $1.12 last week, EUR/USD lost momentum and settled back into the $1.10 range. The impact of Fed-driven dollar weakness appears to be largely priced in, and the yield-driven bullish case seems to have lost steam as ECB rate-cut discussions resurface following last week’s Eurozone inflation report, which hit a three-year low. Additionally, rising political risk in Europe is seen as a challenge for the common currency.

In France, the search for a premier remains unresolved, while over the weekend, populist parties on the extreme right and left made significant gains in German regional elections. Germany’s euro-sceptic party, Alternative for Germany (AfD), celebrated a major victory in the eastern state of Thuringia – its first state parliament win since World War Two. AfD also came a close second in the more populous neighbouring state of Saxony. With federal elections only a year away, the AfD is second in national opinion polls, potentially prompting calls for early elections. Given the earlier turmoil in France this year, investors might become cautious about the implications for European assets, including the euro.

Indeed, EUR/USD one-month risk reversals have turned negative again, indicating a rising premium to protect against a decline in the common currency.

GBP/EUR has been on an upward trend against the Euro for six consecutive months. However, its recent recovery hit a barrier at 1.19, suggesting a potential pullback in the coming days. Last week, the Pound to Euro exchange rate climbed just above 1.19 before retreating, marking this level as a significant resistance point. At 1.19 GBP/EUR, there is notable support at 0.84 in EUR/GBP, which could attract some buying interest in the euro. On the Dollar, Cable managed to break through 1.32 last week and maintained some semblance of support in or around that level.

The RSI indicator is turning downwards, indicating waning momentum and the possibility of a downside movement soon. Despite this, the overall trend remains positive, and any pullbacks are expected to be minor. Support is now at 1.18, aligned with the 50-day moving average. We anticipate the exchange rate to stay above this level if new highs for 2024 are to be achieved in the coming weeks.

The Euro declined last week following lower-than-expected inflation data from Germany and Spain, increasing the likelihood of consecutive rate cuts by the European Central Bank in September and October. However, expectations for an October rate cut became less certain after Eurozone-wide CPI data released on Friday showed rising services inflation, indicating that the disinflation process might be stalling. If expectations for ECB rate cuts diminish further, the Euro could stabilize against the Pound.

With no major data releases from the Eurozone or the UK this week, the GBP/EUR exchange rate will likely be influenced by global risk sentiment. Typically, the Pound rises with positive sentiment and falls when markets retreat. This week is crucial for investors as the final U.S. payroll report before the Federal Reserve’s September interest rate decision is due. While a rate cut later this month is almost certain, the guidance will be key. For the Fed to consider further cuts, evidence of a cooling labour market is needed, making Friday’s report significant. A strong recovery in payroll data could cast doubt on additional rate cuts, potentially boosting the Dollar and impacting stocks negatively.