The euro slipped below the $1.07 mark as investors tread cautiously amidst mixed inflation figures and an unexpected drop in Eurozone economic sentiment. The STOXX 50 ended in negative territory, while the yield on the 10-year German Bund fell below 2.55%, retracting from its recent five-month high.

Preliminary reports revealed that German inflation remained stagnant at 2.2% year-on-year in April, slightly below the market's expectation of 2.3% year-on-year. This was attributed to a slowdown in service inflation offset by a rebound in food prices and a lesser decline in energy costs due to the expiration of a temporary tax cut on natural gas. The EU-harmonized inflation rate came in slightly higher at 2.4% year-on-year, while core inflation, excluding volatile items like food and energy, decreased to 3.0% in April, marking its lowest level since March 2022. Elsewhere in Europe, Spain's Consumer Price Index rose to 3.3% year-on-year, the highest in three months, albeit slightly below market forecasts of 3.4%.

Despite indications that reaching the 2% inflation target is challenging, an ECB rate cut at the June meeting seems increasingly likely, with money markets pricing in a probability of over 90% for easing. However, the path forward remains uncertain. The recent uptick in inflation in the US is raising concerns about spillover effects in the Eurozone, while higher oil prices and a weaker euro could further elevate inflation expectations domestically. The market's fear of a prolonged period of elevated inflation is only matched by concerns about potential policy missteps. Without a clear necessity for a rate cut, there's a growing argument for a wait-and-see approach.

Today's economic calendar is bustling with activity. German retail sales pleasantly surprised, with April figures surpassing market expectations. Later, the Eurozone will release its initial estimates for Q1 GDP and April CPI, with projections indicating a modest uptick in growth accompanied by a slight easing in core inflation. Any positive surprises could lead to a reduction in expectations for rate cuts in the second half of the year, providing support for the euro. Risk sentiment in EUR/USD leans towards a slight decline, as indicated by the skew in overnight risk reversal, with the possibility of choppiness in trading due to month-end dynamics, albeit less pronounced than usual ahead of the looming FOMC meeting.

Last week saw a rebound in the GBP, buoyed by improved risk sentiment, stronger-than-anticipated UK economic data, and relatively hawkish remarks from certain Bank of England (BoE) policymakers.  These factors offset some dovish comments from the preceding week, bolstering the UK currency.  Consequently, money markets scaled back expectations of BoE rate cuts, leading to a shift away from fully pricing in a starting point in August. The UK 10-year government bond yield surged to its highest level in five months.

Looking ahead, we anticipate the GBP/EUR recovery to stabilise above 1.1650 at interbank, potentially testing levels above 1.17, particularly if Eurozone inflation figures come in weaker than expected.  However, both the Eurozone and UK economies face similar prospects, suggesting that central banks are likely to adjust rates more or less in sync, limiting significant trend shifts in the near term.

Any shortfall in Eurozone inflation could prompt the European Central Bank (ECB) to cut interest rates again in July, following its move in June.  The timing of this potential second cut is crucial for markets, considering the well-anticipated June action. Conversely, if inflation figures surpass expectations, the EUR could rally against GBP and USD, as markets would perceive a reduced likelihood of a July rate cut.  A strong inflation print might even cast doubt on the appropriateness of a June cut, further supporting the EUR.

In the US, a slew of market-moving releases, including the Employment Cost Index, ISM manufacturing and services PMI, job openings, factory orders, and the nonfarm payrolls report, will shape market sentiment throughout the week, culminating with the Friday report.  

These incoming data points are pivotal in assessing the trajectory of the US economy, especially as the Atlanta Fed's Nowcast for Q2 US GDP sits at an elevated 3.9%.  Investors anticipate Federal Reserve Chair Jerome Powell to reiterate the central bank's neutral stance in response to higher-than-expected inflation in Q1 during Wednesday's meeting.  However, given the widespread expectation of unchanged policy, attention will likely focus on the Treasuries Quarterly Refunding Announcement (QRA) preceding the FOMC meeting.

Despite retreating from its recent one-week peak above $1.25 yesterday, GBP/USD remains poised to record its most substantial weekly advance in seven weeks. A more balanced tone from Bank of England (BoE) policymakers this week, alongside a string of robust UK economic indicators, notably consumer confidence this morning, have bolstered the pound across the spectrum.

The GfK consumer confidence gauge in the UK surpassed expectations, climbing to -19 in April from -21 in March. Over the past half-year, the composite index has fluctuated between -24 and -19, reflecting sluggish progress amid economic uncertainties. Despite the recent uptick in the UK's unemployment rate to a six-month high, inflation has retreated from nearly 9% to around 3% over the past year, resulting in the UK Misery Index (unemployment + inflation) plummeting to its lowest level since 2021. Given the strong correlation between consumer confidence and the Misery Index, we anticipate a further boost in morale, particularly once the BoE initiates interest rate cuts.

Markets are currently pricing in a mere 40 basis points of rate cuts by the BoE this year, with the initial adjustment anticipated in August. However, we wouldn't be taken aback by a reduction as early as June, possibly totalling 75 basis points for the year, which could cap any GBP appreciation due to unfavorable yield differentials. Nonetheless, absent any intervention from Japanese authorities, GBP/JPY could extend its ascent to new highs not seen since 2015. Following unexpectedly low Japanese inflation figures, the Bank of Japan opted to keep rates unchanged this morning, exerting pressure on the yen across the board.

The USD bounced back after Tuesday's PMI slump, surprising markets with diverging business surveys compared to Europe.  This raised doubts about the idea of US economic superiority, but didn't significantly change the monetary policy outlook. Money markets still anticipate less than two quarter-point rate cuts by the Federal Reserve (Fed) this year, with even a slim possibility of a hike.

While soft data like PMI surveys offer insights into economic trends, they haven't been as influential on markets as hard data, particularly inflation and employment reports.  Therefore, today's US GDP figures, Friday’s PCE inflation report, the upcoming Fed meeting, and jobs data next week will play crucial roles in determining whether the Fed maintains its current policy stance, potentially keeping rates higher for longer and sustaining the dollar's strong performance in 2024.  The USD is expected to continue benefiting from its status as a high-yielding, high-growth, commodity-backed safe haven currency. However, this week's price movements, combined with the overcrowded speculative bets on USD appreciation, raise doubts about the extent of further USD gains, especially with USD/JPY hitting fresh 34-year highs amid growing concerns about Japanese intervention.

Historically, current levels of core, medium, and trimmed inflation momentum have been associated with Fed rate hikes rather than cuts.  Options markets now indicate approximately a one in five chance of a US rate hike within the next 12 months.  If this probability increases or if there's another external shock, such as heightened geopolitical tensions in the Middle East, demand for the dollar will likely remain strong.

GBP maintained its recent gains against the EUR and USD yesterday, buoyed by a survey indicating that British manufacturers are gearing up to increase output in the coming months, driven by growing confidence. GBP/EUR has climbed back above its 200-day moving average support level, although it remains nearly 1% below last week's peak of €1.1735. Meanwhile, following its strongest daily surge of 2024 on Tuesday, GBP/USD is edging closer to $1.25.

The Confederation of British Industry’s (CBI) quarterly Industrial Trends survey revealed that business optimism reached its highest level in almost three years, while sentiment within the manufacturing sector improved significantly, with output expectations hitting a six-month high. However, pressures on prices continued to mount, with the corresponding index reaching its highest level since February 2023. While this data didn't significantly impact the pound, coupled with the positive UK PMI surveys earlier in the week, it suggests a brighter economic outlook for the UK in the long run, which should support the sterling. However, in the short term, a growing disparity in the interest rate outlook between the UK and US could weigh on GBP/USD. Currently, less than two 25 basis point rate cuts are anticipated by both central banks, but there's potential for a more dovish repricing by the Bank of England (BoE), particularly if it acts before the Federal Reserve, a scenario that is becoming increasingly plausible.