Impressive Q3 Performance for the Pound

Following comments from Federal Reserve Chair Powell, the US dollar strengthened, causing GBP/USD to pull back from $1.34 once again. Last week, the pair broke through this key level for the first time in over two years, and managed to surpass it for five consecutive days before closing lower each time. With this pattern, it remains uncertain whether $1.35 is achievable without a new positive catalyst for sterling. However, favourable seasonal trends suggest a strong end to the year. Over the past five years, GBP/USD has risen on average by 1.8% in October, and historically, the fourth quarter has been its strongest by far over the last decade. That said, it’s important not to rely too heavily on seasonality, as evidenced by the pound’s 6% appreciation against the dollar in Q3, despite a 10-year average performance of -2.4%.

From a macroeconomic perspective, revised second-quarter GDP figures released yesterday indicated that the UK economy grew at a slower pace than initially estimated. This was partly due to a higher household savings rate, reaching its highest level since 2021. Although economic activity appears to be moderating and the upcoming Budget on 30 October could further impact consumer spending with higher taxes, growth could remain resilient if households begin spending the savings accumulated since Q1 2023. As a result, the UK’s economic outlook remains more optimistic than that of its European counterparts, explaining the Bank of England’s more cautious approach towards rate cuts. This gives the pound an advantage over the euro in both growth and yield, which has led GBP/EUR to experience a record-breaking monthly run. Sterling also closed the month above €1.20 against the euro, marking its first such achievement since May 2016.

Dollar Rallies as Rate Cut Expectations Ease

After two days of losses, the US dollar regained some strength on Monday, with the US Dollar Index (DXY) rebounding off its 200-week moving average support level. Despite this late recovery, the DXY ended the quarter nearly 5% lower, its worst Q3 performance since 2012. The dollar continues to underperform against commodity-linked G10 currencies and the British pound but has gained against safe-haven and Scandinavian currencies. It was also supported by a cautious sentiment in North American and European equity markets, despite a robust rally in China’s CSI 300, which surged over 8% during Monday’s session.

On the economic front, both the Chicago and Dallas manufacturing indices came in above expectations. The Chicago PMI edged up to 46.6 in September from 46.1 in August. Although it remains in contraction, there were some positive signals, with slight improvements in order backlogs and employment, though declines continued in new orders and production. Moreover, prices paid remained high for the second consecutive month. The combination of better-than-expected data and Powell’s hint at a more gradual pace of rate cuts has led the market to reduce expectations for a November cut slightly. The yield on 2-year US Treasuries rose by 5 basis points, flattening the yield curve further. Market participants now see the probability of a 50 basis point rate cut in November falling below 50%, reflecting increased uncertainty over the necessity of another large rate reduction based on current economic conditions.

Today’s economic calendar features key data releases such as the JOLTS report, which disappointed last month, and the ISM manufacturing index, expected to remain in the 47-48 range. Later in the day, several Federal Reserve officials—Bostic, Cook, Barkin, and Collins—are scheduled to speak, potentially providing further insights into the Fed’s policy outlook. Politically, tonight’s televised debate between US vice-presidential candidates JD Vance and Tim Walz could inject some fresh volatility into FX markets. With Donald Trump having ruled out another debate with Kamala Harris, this will be the last major opportunity for either campaign to make a significant impact in front of voters. Current polling data shows Harris ahead, with a 56-47 margin on PredictIt and a tighter 50.2-48.8 lead on Polymarket.

Softer Inflation Raises Prospects of an October ECB Rate Cut

Germany’s preliminary annual inflation rate fell to 1.6% in September, below the forecast of 1.7% and down from 1.9% in August, marking the lowest level since February 2021. Goods prices declined by 0.3%, while services inflation, closely monitored by the ECB Governing Council, eased slightly to 3.8% from 3.9%. Core inflation also declined to 2.7%—its lowest since January 2022—from 2.8% in August. On a monthly basis, the CPI showed no growth, contrary to expectations of a 0.1% increase. Similarly, the EU-harmonised CPI fell to 1.8% year-on-year, missing the 1.9% forecast, and declined by 0.1% month-on-month.

Since last Friday, preliminary inflation data from France, Spain, and Italy have also come in lower than expected. With these cumulative downside surprises, the ECB has fewer reasons to avoid a rate cut, as evidenced by market pricing, where the probability of an October cut has surged to over 90% in the Overnight Index Swap (OIS) curve, up from 40% just a week ago. Progress in reducing headline inflation has outpaced the ECB’s own projections, while risks to the growth outlook continue to build. Reports emerged yesterday suggesting that Germany’s government is preparing to downgrade its forecast for economic growth to zero for this year, down from a previous estimate of 0.3%.

An October rate cut now seems more likely despite resistance from the ECB’s more hawkish members. Recent macroeconomic data, market pricing, and subtle shifts in ECB rhetoric support this view. Last week, Isabel Schnabel, a key figure on the ECB Governing Council, highlighted increasing growth risks, noting that disinflation remains on track. This sentiment was echoed by ECB President Christine Lagarde, who acknowledged that service prices are easing and core inflation is on a downward trend. Should the ECB opt not to cut rates in October, choosing instead to maintain a quarterly pace of rate changes, markets may view this as a policy misstep, leading to further steepening in the money market curve and raising concerns about the ECB’s credibility.

EUR/USD continued to trade in a volatile manner due to quarter-end flows but ended the day lower. The euro touched $1.12 for the fourth time in seven days but struggled to hold above that level. A key factor limiting the euro’s advance is the widening of front-end rate differentials. While the US-DE 2-year yield spread narrowed to 135 basis points around the time of the Fed’s rate cut, it has since widened to 151 basis points, marking a one-month high.

In related developments, the 10-year OAT-Bund yield spread—a proxy for French risk premium—climbed to 80 basis points, approaching its highest level since late June, amid growing concerns over economic growth. The French government faces a deadline today to present its budget for parliamentary debate, which could lead to additional political turbulence. Credit rating agencies are also set to review France’s fiscal health in the coming weeks, with Fitch and Moody’s scheduled to assess the country on 11 and 25 October, respectively, following an earlier downgrade by S&P Global.