Robust Spending and Strategic Rate Cuts

Throughout 2024, US exceptionalism has been a key theme, bolstering the dollar, bond yields, and equities. Yesterday, the dollar hit new 11-week highs, while stocks rose and bonds dipped, driven by a solid US retail sales report. Jobless claims also dropped by 19,000 to 241,000, reversing a spike from the previous week’s storm-related disruptions. In essence, the US economy is showing strength, making it likely that the Federal Reserve will proceed with cautious rate cuts.

In September, US retail sales grew by 0.4% month-on-month, far exceeding the 0.1% increase seen in August and beating market expectations of a 0.3% rise. This suggests another strong quarter of economic growth, underpinned by solid consumer demand, income growth, access to credit, and a resilient labour market. While the Fed is still expected to cut interest rates by 25 basis points next month, the robust retail figures add weight to the "no landing" thesis, signalling that consumer spending remains buoyant.

Looking ahead, the swaps market now reflects expectations of around 125 basis points of rate cuts through the seven scheduled Fed meetings up to July 2025, indicating the likelihood of two pauses during this period.

Pound Rallies on Strong Retail Sales

Retail sales in the UK unexpectedly rose by 0.3% month-on-month in September 2024, following a 1% increase in August, beating forecasts of a 0.3% decline. Sales at non-food stores surged by 2.5%, driven by strong demand for computers and telecommunications equipment. This positive data has given the pound a solid boost to close the week.

The British pound has climbed back towards $1.31 against the US dollar on the strength of these figures. The pound has also gained against the euro, reaching multi-month highs as the UK’s economic growth and yield differentials work in its favour. However, with several key risks on the horizon, the options market points to increasing downside risks for sterling. One-week and one-month risk reversals for GBP/USD are back in negative territory, indicating a growing preference for hedging against further declines in the pound or strength in the dollar.

Despite a slight retreat from its 2024 highs, one-month implied volatility for GBP/USD remains elevated at over 8%, which is two standard deviations above the year-to-date average of 6.6%.

Euro Weakens Amid Dovish ECB Stance

The euro has extended its three-week decline, weighed down by stronger-than-expected US data and a dovish European Central Bank (ECB) meeting. These developments reflect two major shifts that have turned against the euro. Earlier in the year, the rise of EUR/USD from $1.07 to $1.12 between May and September was based on expectations of a slowing US economy and a belief that the ECB would be less aggressive in cutting rates than the Federal Reserve. However, recent data suggests the US economy is gaining momentum, while economic disappointments in Europe are paving the way for further ECB easing, potentially as soon as December, which could lower the deposit rate to 3% by year-end.

Yesterday's 25 basis point cut was widely expected, with ECB President Christine Lagarde maintaining a data-driven, meeting-by-meeting approach. Yet, mounting downside risks to inflation have opened the door for further cuts. Markets now price in a 20% chance of a 50 basis point cut in December. However, a large cut seems unlikely for two reasons. First, the current easing cycle is already well underway, and a more aggressive move would signal that policymakers may have miscalculated previously. Second, while not stellar, recent economic data, including improved German sentiment and Eurozone industrial production, suggests some signs of recovery.

Looking ahead, the euro is expected to remain under pressure, particularly with the upcoming US election and the increasing likelihood of a Trump victory. The $1.0750 resistance level will be crucial to watch, though absent the political uncertainty, EUR/USD might have settled around $1.10. A win for Harris could push the euro higher, but for now, markets seem to favour Trump’s chances.