Dollar Pauses Near 3-Month High
The Federal Reserve’s Beige Book once again depicts a sluggish US economy, seemingly at odds with the official data. However, this has had little impact on the markets. Instead, several bullish factors are driving the US dollar higher. There is a revival of the US exceptionalism narrative, and the rise in fixed-income volatility, with US yields hitting 3-month highs, is further supporting the dollar. Additionally, geopolitics and domestic politics are lending another layer of strength to the dollar, particularly as improved polling for Donald Trump ahead of the upcoming US election boosts confidence.
Beyond the resurgence of US economic exceptionalism, which is pushing the dollar and yields higher, market sentiment remains convinced that the Republicans are on course for an electoral win. Should this materialise, an increase in tariffs could strengthen the dollar by affecting risk sentiment and slowing trade. If higher tariffs also lead to greater inflation and influence the Federal Reserve’s policy stance, this would provide further support for the dollar through monetary policy channels. In the foreign exchange market, traders are preparing for such an outcome, with EUR/USD two-week implied volatility, which now captures the aftermath of the US election for the first time, recording its second-largest daily jump since the onset of the Covid-19 pandemic in 2020.
Elsewhere in North America, the Bank of Canada joined other central banks with a 50-basis point rate cut yesterday. The yield spread between US and Canadian two-year bonds is now at its widest since 1997, which may continue to put downward pressure on the Canadian dollar, also known as the "Loonie", a trend that could be exacerbated by a Republican victory in the coming weeks.
Sterling Slips Over 3% Month-to-Date
The British pound fell below its 100-day moving average yesterday, trading near $1.29, marking a decline of over 3% month-to-date against the US dollar. The ongoing strength of the dollar is driving the pair lower, and dovish comments from Bank of England Governor Andrew Bailey are further weighing on sterling as traders brace for the release of flash PMIs later this morning.
Bailey suggested that disinflation is occurring faster than expected, hinting that the central bank may continue lowering rates next month. Despite progress on inflation and a cooling in wage growth, traders remain cautious in betting that the BoE will cut rates in both November and December. Although rate expectations haven’t shifted significantly following Bailey’s remarks, and UK gilt yields continue to rise, sterling remains vulnerable to fluctuations in global risk sentiment, falling equities, and broad-based dollar strength as traders pare back expectations for Fed rate cuts and position themselves for what is likely to be a closely contested US election. The clear break below the 100-day moving average opens the door to the 200-week moving average at $1.2850 and the 200-day moving average, which is situated lower at $1.28.
Today’s focus will be on flash industry PMIs, which are expected to show continued expansion in the UK, with all readings anticipated to remain above 50. In September, employment, new orders, and future output expectations in the manufacturing sector fell, likely due to uncertainty surrounding the Budget. Meanwhile, the services sector has remained more resilient, experiencing over a year of expansion, driven by strong domestic demand. This highlights the contrasting performance between the UK and the Eurozone, where activity is contracting, helping the GBP/EUR rate stay around €1.20.
No Free Trade Agreement Spells Trouble for the Euro
The euro has faced numerous challenges over the past four weeks, including disappointing macroeconomic data from Germany, inflation below target in many Eurozone countries, and rising expectations of further monetary policy easing. Political uncertainty surrounding the US election has also weighed on the single currency.
However, deteriorating risk sentiment and falling stock markets have not been part of this narrative – until now. This week has seen a shift, with the S&P 500 on track to record its first weekly loss in eight weeks and volatility, both implied and realised, continuing to rise. This has pushed EUR/USD below $1.08, with $1.0750 now coming into focus.
The euro is not the only currency feeling the pressure of investors positioning themselves ahead of the US election. However, the absence of a free trade agreement (FTA) between the United States and the European Union suggests that economic pain may be on the horizon in the event of a Trump victory and an increase in tariffs. EUR/USD implied one-month volatility has now reached its highest level since early 2023, at 8.3%, and the premium on call options for the same period indicates that investors are more inclined to hedge against further downside risks rather than upside possibilities.
