The US dollar initially weakened after Federal Reserve (Fed) Chair Jerome Powell stated that disinflation appears to be resuming, ending a two-day selloff in the bond market and exerting downward pressure on US yields and the dollar. However, the US JOLTS report suggested the labour market might be strengthening, with job openings and hiring on the rise. This development is bearish for bonds but bullish for the dollar ahead of Friday's jobs data. Despite this, the US dollar index still ended the day slightly lower, with a significant upward tail, indicating bullish fatigue.
Powell warned that maintaining a restrictive stance for too long could cause unnecessary economic pain, but cutting rates too soon could undermine progress in bringing inflation towards the 2% target. The US 2-year yield fell below its 200-day moving average following these comments. Although Powell acknowledged the labour market is becoming better balanced, reducing the risk of another inflation surge, the JOLTS job openings report released shortly afterward exceeded expectations, rising by 221,000 to 8.14 million in May, above the forecast of 7.9 million. This halted the decline in the job openings-to-unemployed ratio, a key labour market indicator for the Fed. Nevertheless, the trend is softening as the US economy moves towards pre-pandemic levels, leaving the possibility of rate cuts later this year open.
We believe the current macroeconomic backdrop supports the expectation of a Fed rate cut in September. Signs of the US economy losing momentum are increasing, with last week's macro data consistently disappointing. Attention is now on Friday's jobs report, the ISM services PMI, and the Fed's meeting minutes today. However, until the Fed starts easing and political risks diminish, the high yield and safe-haven appeal of the US dollar might keep it strong for a while longer.
The euro retreated after a three-day advance, mirroring the performance of most G10 currencies, as ECB policymakers indicated they need more evidence that price pressures are under control. European stocks fell, erasing over half of the previous day's gains, amid ongoing French political uncertainty ahead of Sunday's final round of voting. European government bond yields also declined, but the OAT-Bund 10-year yield spread, a proxy for the French election premium, narrowed further to 72 basis points (-6 bps from Monday), the lowest in almost three weeks.
The preliminary annual inflation rate in the Eurozone eased to 2.5% in June, down from 2.6% in May, aligning with market expectations. Core inflation, which excludes volatile items like food and energy, unexpectedly remained unchanged at 2.9%. The services inflation gauge also held steady at 4.1%. While the headline trend is promising, ECB President Lagarde stated at the ECB Forum that there is not yet sufficient evidence that inflation threats have passed. The region's resilient labour market allows the ECB time to evaluate the appropriate timing and pace of its monetary policy easing cycle but also contributes to upward wage pressures, especially in the services sector, where labour costs significantly influence prices. Currently, money markets are pricing only a 7% probability of a consecutive rate cut in July, consistent with recent ECB communication, and expect 41 basis points of additional easing by year-end.
Realized FX volatility across euro crosses decreased as markets digested key takeaways from the first round of the French parliamentary elections, leading to a wait-and-see approach. The 1-week implied volatility, an option-based measure of short-term expected future volatility, slightly retreated but remains elevated compared to the 2024 average, with near-term market sentiment staying bearish on the euro.
This time tomorrow, British voters will head to the ballot box, with polls still indicating a substantial lead for the Labour Party. Although the lead has slightly narrowed, Keir Starmer's opposition party still holds over a 20-point advantage. Typically, markets are wary of a leadership change, especially with a left-leaning Labour Party. However, this time the markets are hopeful that Starmer’s more centrist, pro-business stance—promising fiscal discipline and improved EU relations—will bring more stability to the UK economy and politics, reassuring investors and boosting the pound.
Currently, amidst this potential Labour victory, rather than being spooked, markets are thriving: British stocks are near record highs, UK bond volatility has diminished, and the pound is the best performing G10 currency year-to-date after the US dollar. Hedging against pound weakness is at a seven-year low. This is a welcome change, given how UK assets have been affected by political drama for many years. Some investors are even betting that UK assets will provide a refuge from political chaos elsewhere, such as in France and the US. However, surprises in politics or markets can never be ruled out, so we remain cautious of potential volatility and unexpected FX movements. The biggest downside risk for the pound would be a hung parliament, where no party has a majority of seats. This scenario, seen in the 2010 and 2017 elections, led to the pound losing over 4% in value within a week. However, this is not our primary expectation.
GBP/USD has risen for four consecutive days, flirting with its 50- and 100-day moving averages, and is in neutral territory according to momentum indicators like the relative strength index. To increase the likelihood of reaching new 2024 peaks soon, we need to see a sustained break above $1.27.
