Treasury Yields Climb Higher
Speculative FX traders have made their most significant move in three years ahead of the US presidential election. Hedge funds and asset managers reduced their short positions against the US dollar by approximately $8 billion in the second week of October. This marks the most substantial shift in sentiment since 2021. Meanwhile, the US dollar index has risen for four consecutive weeks, gaining nearly 4% to reach its highest level in over two months, as US yields climb to fresh three-month highs.
Several factors are boosting demand for the US dollar: US economic outperformance, reduced expectations of Federal Reserve rate cuts, and improving polling for Donald Trump ahead of the election. A potential Trump victory, seen as the more significant market event, could also prompt additional safe-haven flows into the dollar, especially if further risk aversion leads to a notable reduction in liquidity. At the same time, bond markets are under pressure, grappling with concerns that the Federal Reserve may not cut interest rates as much as expected. The MOVE index, which measures expected volatility in the fixed-income market, is now near its highest level this year. This has dampened risk appetite, weakening risk-sensitive currencies while supporting the safe-haven dollar.
Today, attention turns to the Fed's Beige Book on economic conditions. The previous report showed stagnant or declining activity across much of the US, which was one of the reasons behind the Fed’s decision to implement a larger-than-expected rate cut last month. Could another weak report halt the dollar’s upward momentum? Given the US economic surprise index is at a five-month high, this seems unlikely.
Pound Drops to Two-Month Low
The British pound has fallen to its weakest level against the US dollar since mid-August, currently hovering around its 100-day moving average at $1.2865. A decisive break below this level could open the door to the 200-day moving average at $1.28, although the 200-week moving average at $1.2850 should provide strong support.
The currency pair is weighed down by relative growth differentials and safe-haven demand, compounded by a more dovish outlook for Bank of England (BoE) rate expectations. Markets are now pricing in a 70% chance of the BoE implementing a second 25 basis point rate cut in December, following one anticipated in November after weaker-than-expected UK inflation data last week. Investor concerns over bond market volatility are further pressuring the risk-sensitive pound, despite UK yields rising this week. However, sterling remains strong against the euro, holding above the €1.20 mark, buoyed by a widening short-term rate differential, with the two-year spread at its highest in 10 months. GBP/EUR is now around 12% higher than its 2022 low, up 4% year-to-date, and five cents above its five-year average.
There is little economic data on the agenda today, but the release of flash purchasing managers' indices tomorrow could trigger currency volatility, especially if we see any further divergence in economic performance among major economies.
Volatility Puts $1.08 at Risk for Euro
The euro hit a new two-month low during yesterday's session, pressured by rising US Treasury yields and the prospect of a Trump 2.0 presidency. Euro sellers have pushed EUR/USD below the $1.08 mark this morning, as a series of European Central Bank (ECB) speakers failed to generate bullish momentum.
In an interview yesterday, ECB President Christine Lagarde expressed confidence that the inflation target will be sustainably achieved by 2025, following reassuring recent data. She joins a growing list of dovish ECB policymakers, which has led markets to lower their expectations for the ECB’s policy rate. The likelihood of a 50 basis point cut in December is now around 20%. ECB policymaker Mario Centeno has also called for a gradual and steady reduction in interest rates, reflecting a preference for a smaller 25 basis point cut at the year’s final meeting.
Risks to economic growth clearly remain tilted to the downside, but much of the recent pessimism surrounding negative news appears to be priced in, which could be favourable for the euro. Nevertheless, the approaching US election is likely to keep buyers cautious for the time being. US investors have turned net-long on the equity volatility index for the first time this year, and fixed-income volatility has surged to its highest level in 2024. These developments do not bode well for EUR/USD, especially now that the $1.08 threshold has been breached.
