Pressure builds on the dollar
The US dollar continues to slide as expectations grow for the Federal Reserve to embark on a cycle of monetary easing. Market sentiment is divided on whether the Fed will reduce interest rates by 25 or 50 basis points, with the odds evenly split between the two scenarios. This uncertainty has pulled the yield on two-year US Treasury bonds down towards its lowest point in two years, while the US dollar index has weakened to levels last seen in January.
From an investor’s perspective, the dollar is now considered a less desirable asset due to the uncertainty surrounding the Fed’s decision and the possibility of a substantial rate cut. Consequently, the GBP/USD rate surged to its highest in almost three weeks during Monday’s trading session, rising above $1.32 and gaining over 0.6% so far this week. In the short term, the outlook continues to favour a weaker dollar, particularly as the PCE report due at the end of the month is expected to be soft. This should provide the Fed with the justification to reduce rates further at the next meeting and continue its policy of back-to-back cuts. Traders are, in fact, showing a stronger preference for put options betting on a weaker dollar, rather than calls predicting a stronger one, over the coming week and month.
The upcoming US election in November could add another layer of uncertainty for investors, potentially preventing the dollar from a sharp decline. However, the true driver of the Fed’s policy and the future of the dollar will likely be the labour market. A marked decline in the dollar and a significant shift towards other currencies would most likely occur if recession risks in the US increase, further justifying the aggressive market stance on easing.
Euro buoyed by bets on large Fed rate cuts
The euro began the week of the Federal Reserve meeting on a strong footing, rallying above the $1.11 level and posting gains of over 0.4% on Monday. This upward momentum was largely fuelled by an increase in bets on the likelihood of a half-point rate cut from the Fed. Despite this, sentiment around other euro-denominated assets was mixed, with equities trending downwards while bonds remained in demand.
On the domestic front, Monday’s economic data was limited. Italy’s final inflation figure for August was revised down to 1.2% year-on-year, slightly below the initial estimate of 1.3%. The market’s main attention, however, was on speeches from European Central Bank (ECB) officials. ECB’s Kazimir indicated that no rate cuts are likely at the October meeting, suggesting the bank will stick to its usual quarterly approach. He commented that a clearer economic picture would likely only emerge by December, at which point back-to-back cuts would only be considered if there were “significant developments” in the outlook. Similarly, the ECB’s Chief Economist, Philip Lane, supported a cautious and gradual approach, consistent with previous indications of ECB policy changes.
As a result, the implied probability of an October rate cut, as reflected in the OIS curve, dropped from over 45% on Friday to around 30%. Further adjustments in the short-term outlook are expected as the week unfolds. Nonetheless, markets are still pricing in more pronounced ECB rate cuts by 2025, coinciding with an anticipated slowdown in the Fed’s tightening. In the options market, the 1-week EUR/USD implied volatility has been rising for two consecutive days but remains close to the year’s average. With the Fed’s meeting due tomorrow, volatility is likely to increase further over the next 36 hours as traders prepare for the outcome.
Meanwhile, EUR/GBP remains under pressure, as the Bank of England (BoE) is not expected to change its monetary policy at Thursday’s meeting. This has caused the pair to drop to its lowest level in over a week, near 0.8420. However, the euro could see a lift if UK inflation data, due tomorrow, comes in lower than anticipated, potentially fuelling expectations of dovish action from the BoE.
