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.
