The British pound reached its highest level against the euro (€1.1880) since August 2022 amid ongoing political uncertainties across Europe. Since the EU referendum in 2016, GBP/EUR has traded above €1.18 for only 8% of the time over the past eight years. Although political risk will continue to influence the pair in the short term, central bank dynamics will become the primary driver over the long term, leaving the pound vulnerable.

Financial markets are currently pricing in just a 5% probability of a rate cut by next week and only a 40% chance for August’s meeting. However, we believe the market is underestimating the risk of a summer rate cut, given the data from Tuesday showing that UK unemployment unexpectedly rose to a 2½-year high, and the vacancy-to-unemployment ratio has returned to pre-Covid levels. The slowdown in UK private sector pay growth will be welcomed by the BoE, but the trajectory of services inflation will be more crucial in determining the timing and extent of policy easing this year. That data is expected next week. Any signs of cooling UK inflation and an impending summer rate cut could cause GBP/EUR to fall below €1.18 again.

This morning, UK GDP met expectations as the British economy stagnated in April. The 3-month average was 0.7%, despite construction output declining more than anticipated (-3.3% vs. -1.8%). Industrial and manufacturing production also fell more than economists had predicted.

The unexpected shock wave from the European parliamentary elections is still rippling through financial markets. The impact and aftermath of the vote have been magnified due to the absence of other significant market-moving data at the weekly open on Monday. Rising risk premiums, driven by political uncertainty being factored into European assets, have pushed the French 10-year government bond yield to its highest level this year and sent the euro to a one-month low. Short-term implied FX volatility increased slightly, reflecting the scheduled snap election in France at the end of the month. Option traders turned bearish on the euro at the fastest rate in 14 months. While the election has clearly influenced the market, its impact is more pronounced on a regional level than across Europe as a whole. This is evident in the price action: the EUR/USD fell more on Friday following the US non-farm payrolls report (-0.83%) than it did after the election results (-0.58%).

We believe markets have adjusted well to the new composition of the European Parliament. With the initial re-pricing process complete, the medium-term implications for the euro are likely to be more subdued, as the Federal Reserve and US macroeconomic conditions continue to steer the currency's direction. The risk premium due to the upcoming French election could limit significant gains for the euro. Additionally, US election risks will begin to attract attention, meaning political issues will remain a key focus for markets. Political uncertainty, the dollar, and volatility tend to rise in the lead-up to a US presidential election. However, US macroeconomic factors will continue to be the main drivers of price action. If the US economy slows more than expected and the Fed is forced to cut interest rates sooner than anticipated, European political developments will take a backseat to US events.

Christine Lagarde was the first significant central banker to comment on monetary policy following the European Central Bank's interest rate cut last Thursday, the first since 2019. Although the easing was justified by the disinflation observed over the past year or so, rates are not on a steady downward trajectory. She is one of several central bankers scheduled to speak this week. Additionally, the Eurozone will see the release of industrial production, Sentix investor sentiment, and trade balance data.

The Pound Sterling surged on Monday, achieving its best exchange rates for Euro buyers in 34 months. This upward momentum began late on Friday due to a strong U.S. job report that reduced the likelihood of U.S. interest rate cuts. This development also lessened the chances of UK rate cuts, as markets speculated that the Bank of England would follow the Fed in postponing the start of a rate-cutting cycle, boosting UK bond yields and the Pound.

The GBP/EUR price action indicates that the rally is driven by external factors. Performance data shows that the Pound has significantly benefited from the reassessment of U.S. interest rate expectations, appreciating against all G10 currencies except the Dollar. Meanwhile, the Euro has steadily weakened following the European Central Bank's decision to cut interest rates last week.

If regular wages exceed the expected 6.1%, the Pound could rally further, suggesting that the Bank of England's Monetary Policy Committee (MPC) might be cautious about raising interest rates in August to avoid reigniting domestic inflation. Additionally, the UK GDP report due on Thursday is crucial, with markets expecting a 0.1% month-on-month rise for April and a 0.7% year-on-year increase. Any deviation from these expectations could lead to the Pound giving up some of its recent gains.

The GBP/USD exchange rate has been more subdued due to strong U.S. jobs data. The Pound dropped half a percent against the Dollar after U.S. non-farm payrolls rose to 272k in May from 170k in April, surpassing the expected 180k. Average hourly earnings increased to 4.1% year-on-year in May, up from 3.9% in April, exceeding the anticipated 3.9%.

It's a quiet week in the Eurozone, with no major events on the calendar outside of the snap election called by President Macron in France. In the UK, the headline data release is the GDP report on Wednesday, with expectations of a flat result for April. However, the most critical events will be the Fed interest rate decision and the FOMC statement on Wednesday afternoon. Additionally, the US CPI is due on Wednesday, which could introduce some volatility mid-week.

The European Central Bank (ECB) has followed the Bank of Canada as the second major central bank to reduce interest rates this week, lowering its main refinancing rate by 25 basis points to 4.25% overnight.

In an unusual move, the ECB raised its inflation forecasts for 2025 from 2.0% to 2.2%. This adjustment led the central bank to be more cautious about indicating further rate cuts, as higher inflation forecasts typically make additional rate reductions less likely.

Due to the lack of strong signals for future cuts, the euro appreciated following the announcement, with the EUR/USD exchange rate increasing by 0.2%.

Tonight, the spotlight is on the crucial US jobs report. Financial markets are still unsettled after last month’s report missed forecasts for the first time in seven months, compounded by other weakening US labor market data, such as Tuesday’s JOLTS report.

According to Refinitiv, markets are anticipating 185,000 new jobs, up from last month’s 175,000, with the unemployment rate expected to remain steady at 3.9%.

However, another weak number could have a significant impact, potentially causing the USD index to break below support at 104.00, reaching its lowest level since mid-March.