The EUR began the first week of Q3 on a stronger note following an eventful weekend. The initial round of the French parliamentary election saw Le Pen’s far-right party in front of Macron’s centrist alliance, albeit with potentially fewer votes than expected. In early Asia trading hours, EUR/USD and EUR/CHF rose by 0.3% and 0.5%, respectively.  The two significant events influencing the EUR this week are the second round of French parliamentary voting on July 7 and the preliminary Eurozone inflation report on Tuesday.

With three days remaining until the UK general election, international investors seem optimistic about a smooth transition to one of the two traditional governing parties. This sentiment is positive for GBP, gilts, and local equities. Opinion polls in Britain indicate a crushing defeat for the governing Conservatives after 14 years in power. However, Labour’s shift to a more pro-business, centrist position and potentially closer ties with the European Union under their leadership could strengthen GBP as the weekend approaches.  Currently, GBP lacks directional momentum ahead of the election. GBP/USD is hovering below $1.27, while GBP/EUR has dipped under €1.18 for the first time in three weeks.

The first half of the year ended with US and Japanese equities near all-time highs, with political risks resurfacing. The USD marked its fourth consecutive weekly rise, as the first US presidential debate increased Trump’s winning odds to as high as 65%. This was positive for the USD, as a Trump victory could lead to inflationary pressures, prompting the Federal Reserve (Fed) to maintain higher interest rates for longer.

This week in the US, attention will be on the ISM PMIs for the manufacturing and service sectors (June) for signs of economic slowing. The main event will be Friday’s labour market report, with economists expecting a decrease in hiring from 272k to 185k. Additionally, the Fed minutes from the last FOMC meeting may provide insights into policymakers' rationale for revising the expected policy path from three cuts to one this year.

Investors closely monitored the first US presidential debate between Democratic President Joe Biden and Republican rival Donald Trump, which took place early Friday in Asia, ahead of November's US election. Market odds for a Trump victory have narrowed slightly post-debate, potentially indicating upside risks to inflation. This scenario could lead to the Federal Reserve maintaining higher interest rates for a longer period, keeping US Treasury yields elevated and the US dollar strong, hence the uptick in yields and the dollar this morning.

At the same time, signs of the US economy slowing down are becoming more evident as recent macroeconomic data has consistently disappointed. Weaker consumer confidence, declining regional Fed PMI surveys, rising initial jobless claims, and pending home sales hitting a record low have pushed the US surprise index to its lowest level since mid-2022. Despite this, the US dollar index has continued its gradual rise, even though both nominal and real yields fell in June. The macroeconomic and yield-based support that has bolstered the US currency for most of this year is starting to diminish. However, political turmoil in Europe and currency weakness in Asia have enhanced the dollar’s appeal this month. For the dollar to begin losing some of its year-to-date gains, we would need to see a continuation of the global disinflation trend and a reduction in political tensions.

As the first round of the French election approaches this weekend, investors are shifting their attention to the Fed’s preferred inflation gauge today. The market consensus for core PCE is a 0.1% month-on-month increase and a decline in the annual inflation rate from 2.8% to 2.6%.

The euro dropped to a near two-month low of $1.0687 after ECB Governing Council member Rehn hinted at a potential bias towards additional easing this year. Deteriorating risk sentiment led to declines in European equities and a rise in European government bond yield curves, mirroring global trends. The OAT-Bund spread increased to 76.8bps, adding more pressure on the common currency.

Earlier on Wednesday, the euro was already under pressure as the latest survey showed an unexpected drop in German consumer morale for the first time in five months. The GfK Consumer Climate Indicator fell to -21.8 heading into July, down from -21.0, and sharply missing the market consensus of -18.9. Both income expectations and economic prospects declined significantly, leading to a surge in the tendency to save while the propensity to buy remained low. This report marks the third survey this month that has fallen short of expectations, indicating a challenging path to recovery. Despite these challenges, we still expect the German economy to avoid stagflation in the second half of the year.

In the broader FX market, the Japanese yen weakened to a record low of 171.60 against the euro, raising concerns about potential intervention by Japanese authorities to support the struggling currency. Today's US jobless claims numbers and the US presidential debate could impact markets ahead of Friday’s PCE report and the French election vote on Sunday. As the week progresses, EUR/USD is trading at the bottom of its one-month range. With short-term risks leaning to the downside, persistent euro weakness could push EUR/USD to test the April lows around $1.0620.

The US dollar is set for its second consecutive quarter of gains, driven by high inflation-adjusted yields, a robust US economy, and safe haven flows amid political instability in Europe. While these factors support the dollar's strength, significant further gains may be challenging if weak macroeconomic data continues to emerge, increasing downside risks.

In the current low volatility environment, "carry trades" remain popular. This strategy profits from interest rate differentials by borrowing or shorting a low-interest-rate currency to fund or buy a higher-interest-rate currency. The Bank of Japan is in no rush to raise interest rates, keeping its inflation-adjusted rates in negative territory and making the yen a favoured funding currency. In contrast, the US Fed has kept the target range for federal funds steady at 5.25%-5.50% for seven consecutive meetings, with no rate cuts expected until there's more confidence that inflation is moving towards 2%.

In the short term, attention is on Friday's core PCE deflator, the Fed's preferred inflation measure, which is expected to show its slowest monthly increase this year. Rate swaps indicate a 70% chance of a Fed rate cut in September. If inflation is lower than expected, it could prompt a dovish market reaction, potentially weakening the dollar.

The opposition Labour Party maintains a substantial double-digit lead in the polls as the UK election approaches, now just over a week away. Markets generally favor continuity, but Labour's shift to a more pro-business, centrist stance and potential closer ties with the European Union could help reduce the pound's so-called Brexit risk premium. As a result, financial markets remain relatively calm despite the approaching election.

A significant Labour majority seems likely, and investors are increasingly confident that such an outcome would signal a more stable political and fiscal environment for the UK. This contrasts with the growing instability risk in France as it heads into its first-round vote on Sunday. Consequently, despite rate differentials suggesting GBP/EUR should be trading lower, the pound has hit new 22-month highs against the euro and may continue to rise in the short term. GBP/USD has remained above its 50- and 100-day moving averages since the election was called in late May, mostly fluctuating within a $1.26-$1.28 range. Monetary policy has been a major driver of FX trends, which is why GBP/JPY has reached fresh 16-year highs above ¥202, supported by real rate differentials favouring sterling and disadvantaging the low-yielding yen.

From a sentiment perspective, the latest CFTC data shows net long GBP positions held by leveraged funds reached their highest level since September in the week leading up to June 18. This is a bullish sign ahead of the UK vote, but it also increases the risk of profit-taking post-election. Therefore, sterling could weaken after the vote, particularly against currencies like the yen, where overbought signals are evident.

The euro’s strong start to the week was followed by bearish trading due to hawkish comments from Fed's Bowman, which reignited demand for the US dollar. Quarter-end portfolio rebalancing added to the volatility in spot markets, though realized volatility remains low as markets await Friday’s US PCE release.

Domestically, the only surprise was an upward revision in Spain's Q1 GDP, which grew by 0.8%, surpassing the preliminary estimate of 0.7%. This marks the strongest growth rate since Q2 2022 for Europe's sixth-largest economy. Meanwhile, spreads on French bonds decreased from their highest level in over a decade, suggesting that investors are less worried about potential disruptions from the upcoming snap parliamentary elections. The OAT-bund spread narrowed to 75 basis points for the first time in a week but remains 1.5 times higher than the pre-announcement level. The 1-week implied volatility on EUR/USD rose to nearly 8 vol at the start of the week, now factoring in the first round of the French legislative elections. This marks the highest expected volatility, excluding the snap election announcement date, since early January and the widest spread versus realized volatility since March 2023.

Despite expectations of larger spot swings, the euro may remain exposed and range-bound until after the second round of France’s elections on July 7, which could significantly influence the currency. The euro has declined over 1% against the Swiss franc and just over 1.8% against the Norwegian krone compared to its level before the European parliamentary elections. Volatility expectations are focused on shorter-term maturities, leading to an inverse implied volatility term structure for EUR/USD, indicating that the premium for French political uncertainty is expected to fade.