In an attempt to curb consumer price increases, despite a weakening eurozone economy, the European Central Bank has raised interest rates to an unprecedented level. The ECB's governing council in Frankfurt made a finely balanced decision to raise its deposit rate by 25 basis points to 4.5 percent on Thursday, marking the 10th consecutive rate hike. This move coincided with officials lowering their growth projections for the eurozone economy.

Following the ECB's decision, the euro depreciated by 0.24 percent against the dollar, reaching $1.07. Additionally, yields on two-year German Bunds, which are considered a benchmark for the eurozone, decreased by 0.04 percentage points to 3.13 percent.

The ECB's decision was highly significant, with more dovish members of the governing council pointing to indicators of weaker growth, reduced bank lending, a cooling labour market, and declining inflation as reasons to advocate for a pause. In contrast, the hawks expressed concerns that inflation remained excessively high.

Thursday's decision pushed the ECB deposit rate above its previous record high in 2001, when policymakers raised interest rates to bolster the value of the newly introduced euro.  The decision reflects policymakers' greater concern about the risk of sustained consumer price growth exceeding the target, as opposed to the potential for a sharp economic downturn.

In recent weeks, economists have scaled back their growth projections for the eurozone. This adjustment follows declines in industrial production and retail sales observed in July, along with business surveys indicating a further economic downturn in August. Rate-setters believe that the deceleration in economic activity is likely to alleviate inflationary pressures.

Eurozone inflation has already receded from its peak of 10.6 percent last year to 5.3 percent in August.  Anticipated trends indicate a continued decline in inflation, with expectations of reaching the ECB's 2 percent target not until 2025. The recent resurgence in oil prices has raised concerns that the disinflation process may encounter some bumps along the way.

The US Federal Reserve and the Bank of England are scheduled to convene next week.  Many economists anticipate that major central banks are approaching the conclusion of their interest rate hikes, as inflation is declining and economic growth is slowing due to increased borrowing costs.

The Bank of England is anticipated to implement a 0.25% interest rate hike this month, which would push the Bank rate to 5.50%.

Nevertheless, there has been a decrease in the likelihood of additional rate hikes by the end of the year, mainly due to comments from various Bank officials suggesting a shift towards fewer hikes while maintaining elevated interest rates for a longer duration.

Amidst ongoing economic challenges and mounting headwinds, the Bank has acknowledged the genuine risk of tightening monetary policy excessively, which could further hamper growth prospects, particularly since the effects of previous rate increases have not yet fully materialized.

The upcoming week will bring crucial data releases, including vital labor market statistics that continue to be pivotal in shaping the Bank's policy decisions.

In the United States, robust economic data leaves the possibility of one more rate hike on the table before the year concludes, although we do not anticipate any policy changes this month. Market expectations are leaning towards rate cuts commencing in the first half of 2024, as the focus shifts from combating inflation to stimulating economic growth. The next inflation report is scheduled for release next week, and analysts are anticipating a modest uptick to 3.6%.

In Europe, economic data continues to underperform, with markets pricing in only a 30% likelihood of a rate hike at the central bank meeting scheduled for next week.

In the currency markets, the strength of the US dollar remains dominant, driven by the superior performance of the US economy and concerns about the economic outlook in China. As a result, GBP/USD has dipped to a three-month low, falling below the 1.2500 level, while GBP/EUR continues to trade within the well-established range of 1.1500 to 1.1750.

The USD rallied strongly against the CNY, reaching levels close to last year's high of 7.3274, fuelled by the continued upward momentum of the USD. This surge in the greenback can be attributed to the previous day's increase in US yields, driven by the unexpectedly robust ISM services survey for August. This data has instilled greater confidence among investors in the anticipated third-quarter growth surge in the United States. The significant divergence in economic performance between the US, which is experiencing an upswing, and China and Europe, where growth is decelerating, is a key driver behind the sustained appreciation of the US dollar.

The latest ISM services survey revealed an unexpected rise of 1.8 points in business confidence, reaching 54.5, the highest level since February. Additionally, the employment and prices paid sub-components both registered favourable increases of 4.0 and 2.1 points, respectively. These developments prompted a recalibration of expectations in the US rate market, with a higher likelihood now placed on a final interest rate hike later this year and a reduced expectation for rate cuts in the following year. The probability of a near-term Federal Reserve rate hike has moved closer to a 50:50 call, and the expected number of cuts by the end of the next year has decreased to approximately 88 basis points. Notably, almost one 25 basis point rate cut has been removed from expectations since the disappointing NFP report at the beginning of the month.

The momentum of the USD’s surge could intensify if the USD/CNY exchange rate surpasses last year's high. Recent reports from Bloomberg highlight the continued commitment of Chinese policymakers to support the renminbi in order to mitigate its depreciation. The People's Bank of China (PBoC) has consistently set the daily renminbi reference rate stronger than expected for 54 consecutive trading days, marking the longest period of unexpected daily fixes since Bloomberg began its survey in 2018. However, these measures alone may not be sufficient to counteract the upward pressure on the USD/CNY, especially as the US dollar gains strength more broadly, unless there is an improvement in investor sentiment regarding China's economic prospects.

The most recent trade report from China, released overnight, did show some modest improvements in August but fell short of significantly easing concerns about China's economic growth. The report revealed that annual export and import contractions had moderated to -8.8% and -7.3%, respectively. China's trade surplus has remained relatively stable at USD 863 billion over the past year. There is growing speculation that Chinese policymakers may eventually allow for a more substantial devaluation of the renminbi to stimulate growth through net trade. However, their actions so far indicate a preference for a gradual depreciation path, as they are cautious about triggering a sudden surge in capital outflows.

GBPEUR exchange rate is projected to stay above 1.16 in the upcoming days, following a slight dip at the end of August, which fell short around 1.1620. The subsequent recovery indicates the possibility of another attempt to reach the highest levels seen in 2023.  The price movement in GBPEUR continues to display volatility, though it remains within a relatively well-defined range.  The 1.1772 level is once again within reach. However, it's worth noting that in 2023, the pair has not successfully closed above 1.1764 (0.85p). This serves as a reminder that significant resistance exists in this range, typically leading to a decline in GBP and a drop in the exchange rate below 1.17.

The UK economic calendar for this week is relatively sparse, limiting potential for negative developments related to the UK.  Of note this week is the scheduled appearance of the Bank of England's Monetary Policy Committee (MPC) members before the Treasury Select Committee in Parliament on Wednesday. During this session, they will face questioning about the recent updates regarding UK inflation and interest rates.  Following Bank of England Chief Economist Huw Pill's recent statements, it is anticipated that MPC members will signal concerns about persistently high inflation, potentially leading to further interest rate increases. This is likely to strengthen market expectations for another 25 basis point hike in September, which is already factored in, to some degree.

The spotlight today is on members of the European Central Bank (ECB) Governing Council, particularly ECB President Christine Lagarde, who is set to provide remarks at 14:30 BST.  It is expected that ECB members will recognise the ongoing challenges posed by elevated inflation levels in their decision-making process, potentially tilting towards another interest rate increase in September.

On Thursday, the Eurozone GDP for the second quarter is set to be unveiled, with expectations pointing to a 0.3% quarter-on-quarter increase.  If the actual figure falls short of this expectation, it will further support the notion that the economy is facing greater challenges than the ECB initially anticipated. This, in turn, could lead to the belief that the central bank might postpone a rate hike in September, allowing the effects of previous rate hikes to take effect.