Foreign Investors Adjust US Asset Holdings Amid Shifting Rate Cut Expectations

Foreign investors have been steadily increasing their holdings of US assets, expecting future rate cuts to drive yields lower. However, strong US jobs data has prompted investors to reduce these bets, which has, in turn, supported higher US yields and bolstered the dollar's rebound over the past week. Despite some dovish remarks from Federal Reserve policymakers, traders largely ignored them, with the market now pricing in just two rate cuts by year-end, down from three predicted just a few weeks ago.

Sterling Rallies Amid Oil Price Slump and Rising UK Yields

With oil prices dropping around 4% yesterday, the British pound rallied against G10 commodity-linked currencies like the Norwegian krone (NOK). While tensions in the Middle East have pushed oil prices up by over 15% in a month, increased output and demand concerns are acting as counterweights.

The pound, along with the euro, typically weakens when oil prices rise sharply due to the UK and many European nations being net importers of oil, which negatively impacts their terms of trade. This dynamic could be significant if Middle East tensions continue to escalate. 

Another key development is the rise in UK bond yields, with the 10-year yield hitting a three-month high above 4%. However, this hasn't strengthened the pound as expected. The yield gap between UK and German bonds is now the widest in over a year, driven by differing expectations for interest rate cuts and growing concerns over the UK's upcoming budget. Despite this, the GBP/EUR exchange rate remains close to €1.19, still reeling from its largest daily sell-off in two years after Bank of England Governor Andrew Bailey's dovish comments last week.

Global bond market fluctuations are largely influenced by changing expectations around US interest rates, but the rise in UK yields may also reflect growing speculation that the UK government will need to issue more debt to cover a fiscal deficit, dampening the pound's reaction to higher yields.

Euro Consolidates Amid Speculation of ECB Rate Cuts and Economic Uncertainty

The euro remains just below the $1.10 mark after experiencing its second-worst week of the year. Traders are increasingly expecting the European Central Bank (ECB) to cut interest rates by 25 basis points at consecutive meetings in October and December, potentially bringing the deposit facility rate down to 3% from its peak of 4%.

This dovish shift in policy expectations reflects the ongoing weakness in the German economy and falling inflation, which is now below 2% in most European countries. Notably, German ECB board member Isabel Schnabel recently adopted a less hawkish stance, focusing on growth pressures as the labour market cools. This builds further momentum for easing monetary policy.

Additionally, concerns about France's ability to meet the Maastricht guideline of a 3% budget deficit continue to weigh on the euro. The risk premium on French government bonds compared to German bonds remains near its highest level since 2017. These factors suggest a lack of strong domestic drivers for a further EUR/USD rally, although an upward move cannot be ruled out entirely.

Focus on US economic developments may still help limit the euro's downside, especially if weaker macro data or signs of disinflation emerge across the Atlantic. However, with the US election approaching, policy uncertainty remains high, likely keeping demand for the US dollar steady and the euro's movement range-bound until the political landscape becomes clearer.

British Pound Under Pressure Amid Economic Data and Market Sentiment

The British pound remains under pressure this week, hitting its lowest level in nearly a month against the US dollar on Monday. GBP/USD dipped below $1.31, while GBP/EUR fell closer to €1.19, despite rising UK bond yields. The cautious market sentiment during the Asian session, fuelled by a lack of Chinese stimulus announcements, added to the pound’s struggles as it is a risk-sensitive currency.

Data released yesterday revealed that UK salaries increased at the slowest rate in three-and-a-half years in September, signalling a softening labour market. The rising number of job candidates and decreasing demand for staff contributed to wage growth for permanent hires slowing to its weakest since February 2021. This bolsters expectations of more aggressive rate cuts from the Bank of England (BoE). However, despite the soft labour data, UK gilt yields surged to multi-month highs following the strong US jobs report, lending some support to the pound.

Additionally, today's data shows UK retail sales rose by 1.7% on a like-for-like basis in September compared to the same period last year, marking the fastest growth in six months, driven by higher spending on clothing as the holiday shopping season kicks off.

Despite the recent dip, the pound remains the best-performing currency year-to-date, up over 3% against the dollar. With speculative traders still net bullish on the pound, this could prompt profit-taking as year-end approaches, especially with upcoming uncertainties surrounding the UK Budget and the US presidential election.

Euro Struggles Below $1.10 as Economic Weakness and Rising Oil Prices Weigh

The euro remains under pressure, trading below $1.10 this morning, with European equities set to open lower. Chinese markets have also lost momentum since Friday, underperforming global peers. Oil prices have surged, with Brent crude climbing above $80 per barrel for the first time in six weeks, driven by geopolitical tensions between Iran and Israel, impacting pro-cyclical currencies.

The euro's main challenge comes from the reduced expectations of Federal Reserve rate cuts this year, coupled with continued weakness in the German economy. German factory orders dropped 5.8% in August, marking the steepest decline since January 2024. Inflation across major Eurozone economies has also fallen below 2%, increasing the likelihood of a 25 basis point interest rate cut by the European Central Bank (ECB) next week.

Although ECB policymakers have signalled the market to prepare for this rate cut, rising US Treasury yields, driven by strong economic data, have kept German Bund yields from falling. This alignment of monetary policies between the ECB and the Fed has weighed on the EUR/USD exchange rate, which fell from $1.12 to below $1.10 last week.

Pound Faces Worst Week Since July 2023 Amid Economic Pressures

Last week the British pound experienced its steepest weekly decline since July 2023, dropping by 1.8% from $1.34 to $1.31 against the US dollar. Sterling was weighed down by a combination of risk aversion, strong US economic data, and dovish remarks from Bank of England (BoE) Governor Andrew Bailey. As a result, the market has adjusted to anticipate consecutive interest rate cuts in the UK, reducing the rate advantage that had supported the pound earlier in the year.

Upcoming UK GDP data for August, set to be released on Friday, will reveal whether the economy returned to growth after stagnating in July. Meanwhile, downward revisions to final Q2 GDP data and September PMIs have opened the possibility for more aggressive monetary easing than initially expected. This shift, coupled with weakening growth and yield differentials, could keep demand for the pound subdued, potentially testing the $1.30 level for GBP/USD soon.

Despite the recent fall, the pound remains the best-performing G10 currency year-to-date. GBP/USD continues to hold within the top quarter of its 1-, 2-, and 3-year ranges, sitting three cents above its five-year average of $1.28.

U.S. Jobs Report Exceeds Expectations, Easing Concerns Over Labour Market Weakness

The September U.S. jobs report showed unexpectedly strong growth, with the labour market adding 254,000 net new jobs, far surpassing the forecasted 150,000. Additionally, July and August figures were revised upward, breaking the trend of downward adjustments seen in previous months. The unemployment rate also dipped to 4.1%. Combined with earlier data showing steady demand for workers, the report eases fears of a weakening U.S. labour market.

As a result, markets are now pricing in around 50 basis points of easing from the Federal Reserve by year-end, down from the 75 basis points anticipated two weeks ago. The next key test for Federal Reserve policy expectations is this week's U.S. CPI inflation report. However, it is unlikely to reignite expectations of large cuts, keeping the U.S. dollar stable around current levels.

The U.S. economy's resilience, along with diminishing bets on aggressive Fed easing, suggests the dollar's strength could persist. However, improved hopes for a soft landing, combined with China's recent stimulus measures and rising energy prices, may also lift global risk sentiment. In this environment, G10 high-beta currencies, especially those tied to higher commodity prices like the Australian dollar (AUD), Canadian dollar (CAD), and Norwegian krone (NOK), could perform well against the U.S. dollar.

The upcoming U.S. CPI inflation report this week will be the next key indicator for Fed pricing and, consequently, the U.S. dollar.

EUR/USD Falls Below $1.10 as Diverging Central Bank Policies Weigh on Euro

Last week's strong U.S. economic data sharply contrasted with weak Eurozone indicators, such as sluggish manufacturing PMIs and softening inflation. This divergence led to a re-pricing of both central banks' monetary policy outlooks, pushing EUR/USD below $1.10 for the first time in seven weeks. The U.S. Federal Reserve's policy trajectory remains the primary driver of the euro's decline.

Weaker economic activity and faster disinflation in the Eurozone have impacted European Central Bank (ECB) communications and market expectations, with a 95% probability now priced in for a 25-basis-point rate cut in October. As expectations for ECB rate cuts rise, while bets on U.S. Federal Reserve cuts diminish, the narrowing gap in easing expectations has dragged the euro lower. Despite stimulus efforts from China, EUR/USD has struggled to break above $1.12, indicating that any upward movement will depend on U.S. data, monetary policy developments, and factors like the U.S. election and trade policy.

This week, market attention will focus on Eurozone retail sales, ECB meeting minutes (Thursday), and comments from several ECB Governing Council members. With persistent economic weakness and the ongoing pace of disinflation in the Eurozone, further dovish signals from the ECB are likely to keep EUR/USD under $1.10 in the near term.

All Eyes on Key US Data

The US dollar has continued its recent recovery as yields on two-year and 10-year bonds climbed to their highest levels in weeks. This move was driven by Federal Reserve Chair Jerome Powell’s slightly hawkish tone, alongside robust US economic data. Additionally, safe-haven demand for the US dollar, prompted by the escalating conflict in the Middle East, has further buoyed the currency.

In the short term, the dollar’s bullish momentum is expected to persist, underpinned by weakness in other major currencies and ongoing haven demand. The US’s economic strength is also providing support, with the ISM services PMI rising at its fastest pace since February 2023. Nonetheless, the dollar’s longer-term trajectory still leans lower amidst the global easing cycle. Despite this week’s data causing traders to scale back expectations of Fed rate cuts, the odds of a half-point cut in November remain around 65%. Although further cuts are priced in more aggressively for the Fed compared to the ECB and BoE, this could cap the dollar’s gains. However, if yields remain elevated despite rate cut expectations, the dollar could stay supported through November. Market sentiment is also shifting; FX options traders are now the most bullish on the dollar since July, though upcoming US payroll data could change the narrative once again.

Today’s jobs report may well be the pivotal factor determining the Fed’s decision next month. A below-consensus non-farm payrolls figure could see markets price in a greater chance of a substantial 50bp cut in November, thereby weakening the dollar. Conversely, a stronger-than-expected print would support the argument for a more modest 25bp cut, putting the dollar index on track for its strongest week since April.

Bailey’s Comments Send the Pound Reeling

The pound has been hit by a triple whammy of risk aversion, strong US data, and dovish remarks from the Bank of England (BoE). Increased demand for safe-haven assets due to geopolitical tensions, coupled with the pound’s sensitivity to risk, delivered the first blow to GBP/USD. Stronger US data and hawkish signals from the Fed gave the dollar an additional edge. However, the knockout punch came from BoE Governor Bailey, who hinted at a more aggressive approach to rate cuts if inflation continues to ease.

GBP/USD is set for its largest weekly decline since July 2023, having dropped around 1.7% so far. Money markets now fully price in a 25bp cut in November and a 70% chance of another in December, up from around 40% earlier this week. Six rate cuts, up from five, are now priced in by the end of 2025. We have been vocal about the disconnect between BoE pricing and that of its peers, viewing a dovish recalibration as the primary risk to sterling’s outlook. The pound fell by over 1% against both the dollar and the euro following Bailey’s comments, with GBP/EUR posting its worst day since 2022. With bullish GBP positions becoming crowded, the risk is that the pound could decline more sharply if these positions unwind. Sentiment in GBP options has already turned the most bearish since mid-August.

Will the BoE’s Chief Economist, Huw Pill, offer any support for the pound today? Pill, who was one of the dissenters at the August BoE meeting in favour of holding rates, could temper Bailey’s recent dovish tone. However, for the pound to truly recover, a combination of positive UK economic data and a de-escalation of Middle Eastern tensions would be required.

Euro Erases Year-to-Date Gains

The broad euro index has rebounded from three-week lows, supported by upward revisions to the Eurozone services and composite PMIs. Gains of over 0.4% against both the NZD and AUD were bolstered by cautious market sentiment amid the ongoing Israel-Iran conflict, while the pound’s weakness following dovish comments from BoE Governor Bailey led EUR/GBP to surge nearly 1% on Thursday. Nonetheless, EUR/USD remains under pressure as diverging rate expectations continue to weigh on the pair. Market participants have pared back bets on Fed rate cuts, while expectations for an ECB rate cut at its October meeting have increased, putting additional pressure on the euro.

The Eurozone composite PMI was revised higher to 49.6 in September, up from an initial estimate of 48.9, but it still entered contraction territory for the first time since February. While the services sector slowed (51.4 vs 52.9) and manufacturing contracted further (45 vs 45.8), demand for goods and services in the euro area fell at its fastest pace in eight months, leading to backlog reductions and an accelerated rate of job cuts. Business confidence has also softened slightly.

As a result, European equities have declined for the fourth consecutive day, with month-to-date losses approaching 3%. Meanwhile, implied EUR/USD volatility rose to a two-week high ahead of the US non-farm payrolls report. Short-term risk reversals now favour euro puts, reflecting the most bearish sentiment since early August. Unless US jobs data disappoints, the euro is likely to continue its decline, reflecting the region’s ongoing weak fundamentals.