Dollar trims gains despite PMI outperformance
The upward bias on the US dollar arises from the strong performance of the US economy and increasing speculation of a Republican electoral victory, both of which have driven US yields higher across the curve as markets price out Federal Reserve interest-rate cuts. Both presidential candidates are also anticipated to increase the fiscal deficit, setting the US dollar on course for its largest monthly gain in two years. However, with the dollar index in overbought territory, it was unsurprising to see a lull in demand on Thursday, partially due to mixed US economic data.
Unemployment claims were lower than expected, yet continuing claims rose to their highest level since 2021. Regional Federal Reserve activity surveys showed weakness, contrasting with solid PMI figures from the US. The S&P PMI survey outperformed expectations for manufacturing, services, and composite measures, deepening the divide between the US and Europe. Meanwhile, US bond market volatility, as measured by the MOVE index, remains high, benefiting the US dollar, with which it holds a positive correlation. The MOVE index spiked recently as the US election enters its timeframe. Notably, on 7 October, the index experienced its largest single-day percentage surge since 2020, surpassing the Fed’s June 2022 rate hike announcement and the collapse of Silicon Valley Bank in March 2023.
What triggered the jump on 7 October without a clear catalyst? This was the first instance in which the new one-month option on the MOVE index expired after the election. This highlights market sentiment on the extreme risk of yield volatility post-election. In FX, we see similar moves, with EUR/USD hedging costs reaching a seven-year high over the next two weeks.
Pound gains on interest rate outlook
Thursday saw a volatile day for the pound, which was supported by rising 10-year UK gilt yields reaching a 16-week high. Reports indicate that UK finance minister Rachel Reeves may allow increased borrowing in the upcoming budget, potentially delaying Bank of England (BoE) rate cuts. GBP/USD rose through the day but struggled to break above $1.30.
The pound received further support from BoE rate-setter Catherine Mann, who warned that the UK may have eased interest rates too soon. However, weaker-than-forecast flash PMI numbers from the UK likely limited gains. Private sector growth slowed to an 11-month low, with the composite PMI falling to 51.7 in October from 52.6 in September. Services showed slightly stronger growth than manufacturing, but momentum weakened in both sectors. Overnight indexed swaps remain cautious, with market hesitation to price in two full rate cuts from the BoE for the rest of 2024. This has helped GBP/EUR retain its 4% gains year-to-date, supported by the dovish stance of the ECB and the UK-German two-year yield spread, now at its highest in over a year.
Adding to this, UK consumer confidence, as measured by the GfK Consumer Confidence Index, fell to its lowest point of the year. The lack of clarity around government tax plans likely contributes to muted consumer sentiment, despite improving economic indicators.
Gloomy outlook for the euro
The euro has become largely influenced by US developments, with little regard for European macroeconomic data. Global equities rebounded, and US Treasury yields declined in the previous session, allowing EUR/USD to return to the $1.08 range. Increasing options tenors now include US election risks, with the two-week implied-realized volatility spread on EUR/USD reaching its highest level since 2017. Relative hedging costs for the euro have also hit a seven-year peak, underscoring concerns over the European Union’s lack of a free trade agreement with the US.
Eurozone Governing Council members continue to resist aggressive policy easing, with Nagel and Makhlouf stating that 1) significant data would be required for large rate cuts, and 2) the ECB should not rush into easing. However, this position comes amid weak economic data. Europe’s two largest economies remain affected by high interest rates, declining external demand, and structural challenges. Germany’s manufacturing PMI has improved from a one-year low but is still in contraction. The uncertain business outlook continues to hinder investment, with France’s manufacturing outlook negative for 21 consecutive months and no signs of recovery. Business expectations are currently at their most pessimistic since May 2020.
