Volatility Surges Amid Iran-Israel Conflict

Geopolitical tensions triggered a surge in demand for safe-haven assets yesterday. Gold, bonds, and currencies such as the USD, JPY, and CHF all rallied, while equities and risk-sensitive currencies like the GBP fell sharply. The VIX index, Wall Street’s so-called “fear gauge”, rose above its long-term average, indicating the likelihood of increased volatility ahead. Traders also noted that the VVIX – which measures the expected volatility of the VIX itself – has remained elevated above its long-term average for several months, signalling sustained anxiety in the markets.

Tensions in the Middle East have been simmering all year, with markets mostly focused on macroeconomic and monetary policy developments. However, a report that the US was actively preparing to support Israel against a potential ballistic missile attack prompted a flight to safety. This was swiftly followed by Iran launching around 200 missiles, raising the stakes for an Israeli retaliation. The extent of Israel’s response will determine how much additional geopolitical risk gets factored in by markets. Oil prices have already spiked 5% as the risk of a broader conflict rises. Given the speculative short positions in oil, this rally could gain momentum if these positions are unwound. Currencies of oil-exporting nations, such as NOK and CAD, appreciated as a result of surging oil prices, with GBP/CAD falling over 1% on the day.

Volatility has been subdued for much of the past two years, but the recent bouts over the last few months may be a warning that markets have entered a new regime – particularly with rising geopolitical risks and the US election looming. This scenario does not bode well for the risk-sensitive pound, which has already shed two cents from its 31-month high against the US dollar, reached just last week.

Mixed US Data Keeps 50 Basis Point Cut in Play

A slew of mixed US economic data released yesterday failed to alter the risk-off sentiment in financial markets, as the US Dollar Index climbed to its highest level in three weeks. Keeping a close eye on US data remains crucial, as markets continue to price in the likelihood of another 50 basis point interest rate cut by the Federal Reserve (Fed) before year-end.

US manufacturing activity contracted for the sixth consecutive month in September, reflecting weak orders and declining employment. The prices-paid index fell 5.7 points, the most since May 2023, to 48.3 – marking the first time this year that overall costs have decreased. The survey, however, was conducted prior to a strike at ports on the East and Gulf Coasts, the first in nearly 50 years, which could potentially drive up shipping costs and import prices going forward. Coupled with surging oil prices and supply chain disruptions, inflationary concerns could resurface. Furthermore, despite the weak employment index in the PMI survey, an uptick in job openings from the JOLTS report alleviated some concerns over the labour market. This complex backdrop could cause the Fed to reconsider the pace of its policy easing.

Earlier this week, Fed Chair Jerome Powell downplayed the likelihood of another large cut, suggesting that two quarter-point rate cuts by year-end were a base case. This led to a pullback in rate futures, which are now reflecting just 70 basis points of Fed cuts by the end of the year, down from over 75 basis points previously. Although yesterday’s data was overshadowed by escalating tensions in the Middle East, it makes Friday’s payrolls report a crucial factor in determining whether another significant cut will be on the table in November.

Eurozone Inflation Falls Below 2%

The euro depreciated amidst escalating geopolitical tensions and a preliminary report showing that Eurozone inflation has dropped below the ECB’s 2% target for the first time since 2021. European equities retreated, while bonds rallied as risk-averse sentiment took hold. The long-end of the German sovereign yield curve saw robust buying, leading to a bull flattening, with the 2-10 year spread narrowing to roughly 2.4 basis points, a one-week low.

In September, consumer prices increased by 1.8% year-on-year, down from 2.2% in the previous month, primarily due to a steep decline in energy costs. Energy prices continued to fall, and inflation in services slowed to 4% from 4.1%, although prices for food, alcohol, and tobacco edged up slightly. Core inflation also eased to 2.7% from 2.8%. Despite this moderation, the ECB anticipates that inflation will rise again later in 2024, as the sharp declines in energy prices fall out of the annual comparison. However, the recent drop in inflation below the ECB’s target has led investors to increase their expectations of rate cuts. An October rate cut is now nearly fully priced in (23 basis points), with market participants projecting further rate reductions through to May 2025. The 2-year Bund yield fell below 2% for the first time since 2020, and the implied terminal rate has dropped below 1.65%, hitting a multi-month low.

This dovish outlook has rekindled bearish sentiment towards the euro, pushing EUR/USD below the short-term support level of $1.11, marking a two-week low. The broader Euro index also declined, particularly against safe-haven currencies. Should this momentum persist, EUR/USD could slide further towards the 50-day moving average of $1.1036 in the near term.

Elsewhere, French Prime Minister Michel Barnier announced a two-year delay to the target for reducing the country’s budget deficit within the EU’s 3% limit, allowing more time to address public finances. Barnier warned that the deficit could exceed 6% this year. The market reacted negatively, with the yield on French 10-year bonds rising from an intraday low of 2.78%. The CAC 40 fell 1%, partly due to the deficit news, but also on headlines concerning an imminent Iranian attack on Israel. As a result, the 10-year OAT-Bund spread widened by 4 basis points, reaching 78 basis points.

Impressive Q3 Performance for the Pound

Following comments from Federal Reserve Chair Powell, the US dollar strengthened, causing GBP/USD to pull back from $1.34 once again. Last week, the pair broke through this key level for the first time in over two years, and managed to surpass it for five consecutive days before closing lower each time. With this pattern, it remains uncertain whether $1.35 is achievable without a new positive catalyst for sterling. However, favourable seasonal trends suggest a strong end to the year. Over the past five years, GBP/USD has risen on average by 1.8% in October, and historically, the fourth quarter has been its strongest by far over the last decade. That said, it’s important not to rely too heavily on seasonality, as evidenced by the pound’s 6% appreciation against the dollar in Q3, despite a 10-year average performance of -2.4%.

From a macroeconomic perspective, revised second-quarter GDP figures released yesterday indicated that the UK economy grew at a slower pace than initially estimated. This was partly due to a higher household savings rate, reaching its highest level since 2021. Although economic activity appears to be moderating and the upcoming Budget on 30 October could further impact consumer spending with higher taxes, growth could remain resilient if households begin spending the savings accumulated since Q1 2023. As a result, the UK’s economic outlook remains more optimistic than that of its European counterparts, explaining the Bank of England’s more cautious approach towards rate cuts. This gives the pound an advantage over the euro in both growth and yield, which has led GBP/EUR to experience a record-breaking monthly run. Sterling also closed the month above €1.20 against the euro, marking its first such achievement since May 2016.

Dollar Rallies as Rate Cut Expectations Ease

After two days of losses, the US dollar regained some strength on Monday, with the US Dollar Index (DXY) rebounding off its 200-week moving average support level. Despite this late recovery, the DXY ended the quarter nearly 5% lower, its worst Q3 performance since 2012. The dollar continues to underperform against commodity-linked G10 currencies and the British pound but has gained against safe-haven and Scandinavian currencies. It was also supported by a cautious sentiment in North American and European equity markets, despite a robust rally in China’s CSI 300, which surged over 8% during Monday’s session.

On the economic front, both the Chicago and Dallas manufacturing indices came in above expectations. The Chicago PMI edged up to 46.6 in September from 46.1 in August. Although it remains in contraction, there were some positive signals, with slight improvements in order backlogs and employment, though declines continued in new orders and production. Moreover, prices paid remained high for the second consecutive month. The combination of better-than-expected data and Powell’s hint at a more gradual pace of rate cuts has led the market to reduce expectations for a November cut slightly. The yield on 2-year US Treasuries rose by 5 basis points, flattening the yield curve further. Market participants now see the probability of a 50 basis point rate cut in November falling below 50%, reflecting increased uncertainty over the necessity of another large rate reduction based on current economic conditions.

Today’s economic calendar features key data releases such as the JOLTS report, which disappointed last month, and the ISM manufacturing index, expected to remain in the 47-48 range. Later in the day, several Federal Reserve officials—Bostic, Cook, Barkin, and Collins—are scheduled to speak, potentially providing further insights into the Fed’s policy outlook. Politically, tonight’s televised debate between US vice-presidential candidates JD Vance and Tim Walz could inject some fresh volatility into FX markets. With Donald Trump having ruled out another debate with Kamala Harris, this will be the last major opportunity for either campaign to make a significant impact in front of voters. Current polling data shows Harris ahead, with a 56-47 margin on PredictIt and a tighter 50.2-48.8 lead on Polymarket.

Softer Inflation Raises Prospects of an October ECB Rate Cut

Germany’s preliminary annual inflation rate fell to 1.6% in September, below the forecast of 1.7% and down from 1.9% in August, marking the lowest level since February 2021. Goods prices declined by 0.3%, while services inflation, closely monitored by the ECB Governing Council, eased slightly to 3.8% from 3.9%. Core inflation also declined to 2.7%—its lowest since January 2022—from 2.8% in August. On a monthly basis, the CPI showed no growth, contrary to expectations of a 0.1% increase. Similarly, the EU-harmonised CPI fell to 1.8% year-on-year, missing the 1.9% forecast, and declined by 0.1% month-on-month.

Since last Friday, preliminary inflation data from France, Spain, and Italy have also come in lower than expected. With these cumulative downside surprises, the ECB has fewer reasons to avoid a rate cut, as evidenced by market pricing, where the probability of an October cut has surged to over 90% in the Overnight Index Swap (OIS) curve, up from 40% just a week ago. Progress in reducing headline inflation has outpaced the ECB’s own projections, while risks to the growth outlook continue to build. Reports emerged yesterday suggesting that Germany’s government is preparing to downgrade its forecast for economic growth to zero for this year, down from a previous estimate of 0.3%.

An October rate cut now seems more likely despite resistance from the ECB’s more hawkish members. Recent macroeconomic data, market pricing, and subtle shifts in ECB rhetoric support this view. Last week, Isabel Schnabel, a key figure on the ECB Governing Council, highlighted increasing growth risks, noting that disinflation remains on track. This sentiment was echoed by ECB President Christine Lagarde, who acknowledged that service prices are easing and core inflation is on a downward trend. Should the ECB opt not to cut rates in October, choosing instead to maintain a quarterly pace of rate changes, markets may view this as a policy misstep, leading to further steepening in the money market curve and raising concerns about the ECB’s credibility.

EUR/USD continued to trade in a volatile manner due to quarter-end flows but ended the day lower. The euro touched $1.12 for the fourth time in seven days but struggled to hold above that level. A key factor limiting the euro’s advance is the widening of front-end rate differentials. While the US-DE 2-year yield spread narrowed to 135 basis points around the time of the Fed’s rate cut, it has since widened to 151 basis points, marking a one-month high.

In related developments, the 10-year OAT-Bund yield spread—a proxy for French risk premium—climbed to 80 basis points, approaching its highest level since late June, amid growing concerns over economic growth. The French government faces a deadline today to present its budget for parliamentary debate, which could lead to additional political turbulence. Credit rating agencies are also set to review France’s fiscal health in the coming weeks, with Fitch and Moody’s scheduled to assess the country on 11 and 25 October, respectively, following an earlier downgrade by S&P Global.

The Pound to Euro exchange rate could see further gains in the coming days as positive momentum continues to build. Despite a one percent rise in September, the Pound faces significant resistance at the 1.2022 level, which was last week's peak. If momentum remains strong, there is potential for the Pound to move towards 1.2099 in the near term, though a pullback could occur before reaching this level. Similarly, GBP/USD faces substantial resistance at 1.34, a threshold that will require a significant event or economic shift for the pair to break and sustain support above.

The 1.20-1.21 range remains critical for the Pound, as it hasn’t been sustained above these levels since 2016. Technical indicators are supportive of further gains, with the Relative Strength Index (RSI) at 65 and trending higher. However, a move beyond this range would require a significant divergence between Eurozone and UK economic conditions. Without such a divergence, there’s a risk that the Pound’s rally could stall or enter a period of consolidation. Similarly, for GBP/USD to overcome 1.34 resistance, a strong catalyst—such as a major central bank decision or shift in U.S. economic data—would be necessary.

Upcoming Eurozone inflation data could increase the likelihood of another European Central Bank rate cut. Meanwhile, U.S. data will play a critical role in shaping global risk sentiment and influencing the Pound’s movements. Markets will be watching U.S. PMI data and Federal Reserve speeches closely, as these could signal future U.S. interest rate policy. A weaker-than-expected non-farm payroll report on Friday would likely boost expectations for further Fed rate cuts, which could support the Pound. However, stronger data could dampen sentiment, limiting the Pound’s upside and keeping GBP/USD below the 1.34 resistance.

Pound Sterling's Strength: On Track for a Third Weekly Rise Against USD and EUR

The British pound is heading for its third consecutive weekly gain against both the US dollar and the euro, reaching over two-year highs this week. Growth and yield differentials have favoured sterling recently, with increased risk appetite further boosting its performance.

The primary bullish factor for GBP this year has been interest rate and yield differentials, as the Bank of England (BoE) has adopted a more cautious stance on cutting interest rates compared to its peers. Market expectations reflect this, with fewer rate cuts anticipated in the coming years. Currently, only 40 basis points of BoE easing are priced in before year-end. However, there is a downside risk to the pound, as the BoE may cut rates at both its November and December meetings, particularly if services inflation decreases.

Growth divergence is also at play, especially in the GBP/EUR pair. Despite some underwhelming PMI survey results in the UK, overall private sector activity has expanded for eleven consecutive months, reflecting a healthier UK economy compared to Europe. Political challenges in Europe further weaken the euro, giving the pound an additional advantage.

For GBP/EUR, holding above the €1.20 level is crucial for establishing a new trading range. The pair has already broken above its 200-month moving average, suggesting it could achieve its strongest Q3 performance since 2014. Similarly, GBP/USD is on course for its best Q3 since 2013, and its fifth-best on record, defying typical seasonal patterns.

Dollar Downtrend Pauses Amid Mixed US Data and Uncertainty

The recent decline in the US dollar has slowed this week, supported by mixed economic data. Revised GDP figures revealed stronger-than-expected economic growth in the second quarter, while durable goods orders remained flat. Additionally, US unemployment claims dropped by 4,000 to 218,000, marking a new 4-month low and highlighting the labor market's resilience. However, earlier data showed a worsening labour market differential, suggesting a higher unemployment rate in the upcoming September jobs report, which could pave the way for another significant Federal Reserve rate cut later this year.

In the short term, monetary policy dynamics continue to influence the currency markets, signalling further potential dollar weakness. A wave of global stimulus measures boosting risk appetite may also weigh on the safe-haven dollar. However, the upcoming US election in November introduces uncertainty into this bearish outlook. A Republican victory, particularly a clean sweep, is seen as the most USD-positive scenario.

Concerns Rise Over Potential Acceleration of ECB Rate Cuts Amid Economic Struggles

Markets are growing increasingly worried that the European Central Bank (ECB) may speed up its rate-cutting efforts, possibly shifting from its usual quarterly pace at the upcoming October meeting due to deteriorating economic conditions. Although Germany's GfK consumer climate indicator showed slight improvement, persistent declines in consumer sentiment and a rise in savings signal continued obstacles to the region’s recovery. The likelihood of a rate cut at the October meeting has risen to over 60%, up from 40% earlier in the week.