Coin Toss Decision in the Spotlight

The US dollar received a boost after US retail sales unexpectedly rose by 0.1% in August, defying predictions of a 0.2% month-on-month decline. However, the report failed to clarify the size of the interest rate cut the Federal Reserve (Fed) is expected to announce today, with market expectations still evenly split between a 0.5% and a 0.25% reduction.

Despite the positive surprise in the headline figure, the three-month moving average for retail sales shows a slowdown in consumer spending this year compared to 2023. The average monthly increase has fallen to 0.13% this year from 0.46% last year. With consumer spending moderating, inflation declining, and rising risks to the labour market, it seems likely the Fed will adopt a dovish stance today, signalling the start of an easing cycle. There’s also speculation that market pressure may push the Fed towards a larger rate cut. If market expectations of a significant cut strengthen, the Fed could deliver it, which would likely drive the dollar lower and potentially push the pound, euro, and yen to multi-year highs.

However, could this be one of the rare meetings where the Fed doesn’t follow market sentiment? Some policymakers may resist such an aggressive move, given that the US economy remains robust, unemployment is low, inflation is above target, and stock markets are at record highs. Therefore, a 25-basis-point cut is still possible, which could limit the dollar's weakness in the short term.

UK Inflation Meets Expectations

UK inflation data for August matched forecasts, with the annual rise in CPI holding steady at 2.2%, exceeding the Bank of England's (BoE) target for a second consecutive month. Core CPI increased to 3.6% from 3.3%, while services CPI, the BoE’s preferred measure, climbed to 5.6% from 5.2%, both in line with expectations. Following the release, the pound strengthened slightly, with GBP/USD trading in the upper $1.31 range and GBP/EUR steady around €1.18.

Given that the data aligned with expectations, and the rise in core and services inflation was largely driven by base effects and volatile hotel prices linked to Taylor Swift’s tour, this is unlikely to have a major impact on the BoE’s upcoming monetary policy decision. The consensus is that policymakers will hold rates at 5%, with markets only pricing in a 25% chance of a rate cut. With wage growth slowing in July and signs of moderating economic activity raising concerns about the UK’s economic outlook, inflation may become less of an issue. We expect the BoE to start its easing cycle in November. However, much will depend on the size of the Fed's rate cut and its forward guidance, which could influence the BoE’s future decisions.

At present, rate differentials favour the pound, with the BoE seen as the least dovish of the G3 central banks over the coming years. However, this assumption could be challenged if the BoE adopts a more dovish stance. Overnight volatility in the pound has risen to its highest since August 2023, as traders position themselves ahead of policy announcements from both the Fed and the BoE.

Euro Unfazed by ZEW Decline

The euro slipped slightly but remains above the key $1.11 level as markets await the outcome of the Federal Reserve meeting, with debate continuing over the likelihood of a larger 50-basis-point rate cut. European stocks and bonds have reversed their earlier trends, with the Stoxx50 equity index gaining nearly 0.7% on the day, while bonds fell, reflecting global market dynamics.

On the economic front, the ZEW Indicator of Economic Sentiment for Germany dropped sharply in September, falling to 3.6, its lowest level since October 2023, from 19.2 in August. The current conditions index also fell to its lowest point since May 2020, dropping to -84.5 from -77.3. Similarly, the Eurozone-wide ZEW measure fell to an 11-month low of 9.3, well below the expected 16.3, highlighting ongoing uncertainty about the economic outlook and the future of monetary policy. Despite these disappointing indicators, the European Central Bank (ECB) is in no hurry to accelerate its easing cycle. Several members of the ECB's Governing Council, including Simkus, have signalled that the December meeting is the most likely time for a third rate cut, with little chance of a cut in October—markets currently price a roughly 30% probability of such a move.

In the options market, sentiment has turned more bullish on the euro ahead of the Fed decision. One-week EUR/USD risk reversals are increasingly skewed towards euro calls, with the spread reaching nearly 0.7 vol—indicating the most bullish outlook for the euro in nearly four years. While a smaller 25-basis-point Fed cut could lead to some profit-taking on the euro, it is more likely to moderate further dollar weakness rather than trigger a significant reversal in the euro’s trajectory.