The Pound Sterling reached its highest level against the Euro in 21 months on Wednesday, closing at 1.1759. This marks the highest daily finish since August 2022, driven by a recovery in global equity markets, which typically benefits the risk-sensitive Pound.

However, the Pound faces potential challenges today due to the European Central Bank's (ECB) decision. Euro exchange rates will be under scrutiny as the ECB cuts interest rates and provides guidance on the timing of the next cut. While the June cut has been anticipated for weeks, the focus for currency markets will be on when the subsequent cut might occur.

Markets indicate low odds of the ECB delivering a follow-up rate cut in July, as a recent rise in inflation is expected to prompt the ECB's Governing Council to proceed cautiously.  The concern is that cutting rates too quickly and too significantly could exacerbate inflationary pressures.  ECB President Christine Lagarde might express concerns about inflation while acknowledging that the Eurozone's economy has shown improvement since the last meeting.

On Tuesday, the risk-sensitive pound was influenced by renewed global risk aversion as investors sought safety in traditional safe-haven currencies like the US dollar, Japanese yen, and Swiss franc. This shift was triggered by the surprising outcome of India's election, where Narendra Modi lost his parliamentary majority.

Markets had anticipated a landslide victory as predicted by exit polls, but this result highlighted the unreliability of polls. The election outcome was much closer than expected, and the resulting coalition government spurred a wave of demand for safe-haven assets, boosting the Japanese yen. The yen was further supported by hawkish remarks from a Bank of Japan (BoJ) official, who hinted at scaling back bond purchases in the upcoming meeting this month. This led to a bullish shift in yen risk reversals across several tenors, indicating the strongest positive sentiment in weeks. As a result, USD/JPY fell to two-week lows, while GBP/JPY and EUR/JPY experienced their largest daily drops in over a month, with the former falling from ¥200 to nearly ¥197. Although the yen has since given up most of these gains, increasing volatility suggests potential for further strengthening amidst divergent monetary policies and political developments.

These recent political and monetary policy surprises underscore the sensitivity of certain currencies. Significant fluctuations can occur rapidly, especially with the yen. The British pound, also a risk-sensitive currency, is susceptible to substantial swings, particularly periods of weakness during heightened risk aversion. This is crucial to consider with upcoming central bank meetings and elections in Europe, the UK, and the US.

The euro depreciated for the first time since last Wednesday as risk-off safe-haven flows dominated the markets. German unemployment claims unexpectedly rose by 25,000, compared to the anticipated 10,000, while the unemployment rate remained steady at 5.9%. Despite this, investors have reduced their expectations for European Central Bank (ECB) policy easing this year, primarily due to the surprising inflation increases over the past two months. The inflation uptick in May led some policymakers to adopt a more hawkish stance, casting doubt on the likelihood of consecutive rate cuts in July.

Some central bankers, particularly from Germany, appear to have ruled out policy easing at the July meeting. However, ECB pricing still tends to follow the Federal Reserve. This means that a potential downturn in the US economy and the end of US exceptionalism could reintroduce some of the rate cuts that were previously priced out. Despite the recent depreciation, the euro is still on track to appreciate for seven out of the last eight weeks, influenced by last week’s persistent inflation report.

EUR/USD is holding above the $1.0880 level, but momentum will need to be confirmed by today's US ISM PMI data and Thursday’s ECB rate decision. Any significant positioning is likely to be cautious and limited ahead of the US labour market report on Friday.

The US dollar has weakened against most G10 currencies. GBP/USD has reached fresh 12-week highs above $1.28, while EUR/USD has reclaimed $1.09 for the first time since mid-March. This dollar weakness is due to declining yields following the US ISM manufacturing PMI report, which confirmed trends of slowing growth, decelerating inflation, and a tight labour market. Investors are closely monitoring data to assess how long the narrative of US exceptionalism can persist. The nonfarm payrolls report on Friday will be a critical event for cross-asset developments. Yesterday, the US manufacturing PMI surprised markets with a decline from 49.2 to 48.7 in May, impacting the US currency. Notably, the employment category showed improvement after seven months of contraction. JOLTS job openings will be important today, followed by services PMI on Wednesday and the eagerly anticipated jobs report on Friday

The key event this week will be the widely anticipated ECB policy rate decision on Thursday.

GBP fell from 21-month highs against the EUR following Friday’s release of higher-than-expected Eurozone inflation data, disrupting a bullish technical setup and raising the potential for a deeper pullback to £/€ 1.17 or lower at interbank.

The recent strength of GBP has been driven by diminishing expectations for a June rate cut by the Bank of England (BoE). Markets now do not fully anticipate a rate cut by August. In contrast, the European Central Bank (ECB) is expected to cut interest rates this week, creating a clear divergence in monetary policy between the UK and Eurozone that supports GBP gains. Since markets already anticipate an ECB rate cut on Thursday, the actual decision won't be surprising; instead, market movements will be influenced by guidance on future rate cuts.

In addition to central bank actions, economic data will also be in focus this week. China will release Caixin PMI numbers on Monday, Australia will report March-quarter GDP on Wednesday, and the US will build up to Friday’s non-farm payrolls (NFP) report.

Last month, the NFP report missed forecasts for the first time since October, triggering a USD sell-off and leading to the greenback's first monthly decline in 2024.