The Federal Reserve’s latest decision, one of the most eagerly awaited in recent memory, ended up being somewhat underwhelming for traders hoping for a more enthusiastic market response. The US central bank made a bold move by cutting its benchmark interest rate by a substantial 50 basis points, bringing it down to a target range of 4.75% to 5.0%. This marked the first reduction in over four years, and the largest in sixteen. Initially, markets reacted with a surge in equities to record highs, a fall in short-term bond yields, and the US dollar index hitting a 14-month low. However, after some early volatility, the market largely shrugged off the decision as Fed Chair Powell struck a more balanced tone, which curbed the initial rally.

Powell sought to present the 50-basis point cut as a precautionary step, rather than a reactive one due to labour market pressures. Alongside this hefty cut, the median dot plot was adjusted to reflect two further 25-basis point reductions in the next two meetings, which would bring the year-end policy rate to between 4.25% and 4.50%, still slightly above current market expectations. The unemployment forecast for 2024 was revised upwards to 4.4%, while headline inflation estimates were brought down to 2.3%. Notably, Governor Bowman dissented from the decision, marking the first such opposition from a Governor since 2005, hinting at potential divisions within the Fed. A significant portion of policymakers, in fact, only foresee one cut in 2024, differing from the median projection of two cuts.

Overall, the FOMC appears less dovish than the official statement suggests, and there may be further dissent in the final two meetings of the year. Powell’s decision to act aggressively indicates the Fed prioritises market stability over internal agreement. This is a delicate balancing act, and despite the market's initial reversal, we maintain a view that supports a bearish stance on the dollar, given that US interest rates are likely to decline more swiftly than in other major economies.

As a result of the Fed's sizeable rate cut, sterling soared to fresh two-year highs against the dollar, though GBP/USD quickly reversed from the $1.33 mark as the dollar regained ground, thanks to Powell’s careful approach. Attention now shifts to today’s Bank of England (BoE) meeting, where the consensus is that the Bank Rate will remain unchanged at 5%, consistent with the data and signals since August’s meeting. Given that markets have already priced this in, any movement in the pound could be limited.

Nevertheless, we believe the pound will continue to perform strongly against the dollar, largely due to the growing interest rate gap between the UK and the US. The BoE seems more concerned with inflation compared to the Fed. Yesterday’s jump in UK core and services inflation prompted a drop in market pricing for a BoE rate cut, falling from around 30% to 15%, with expectations for total easing by year-end reducing slightly from 54 basis points at the start of the week to 48 basis points. While we expect the BoE to hold firm today, we don’t believe the latest inflation data will prevent rate cuts in November. Services CPI has been erratic, driven mostly by base effects and price categories that seem less significant to the BoE. Coupled with signs of slowing wage growth and moderating economic activity, barring any major surprises, we anticipate back-to-back rate cuts in November and December.

In summary, GBP/USD continues to closely track the expected rate differentials between the UK and the US this year. The Fed’s outlook, given its pro-cyclicality and sensitivity to risk, seems to hold more influence over sterling’s direction. Barring any external shocks, we expect the pound to test the $1.33 level once again in the near future.

Coin Toss Decision in the Spotlight

The US dollar received a boost after US retail sales unexpectedly rose by 0.1% in August, defying predictions of a 0.2% month-on-month decline. However, the report failed to clarify the size of the interest rate cut the Federal Reserve (Fed) is expected to announce today, with market expectations still evenly split between a 0.5% and a 0.25% reduction.

Despite the positive surprise in the headline figure, the three-month moving average for retail sales shows a slowdown in consumer spending this year compared to 2023. The average monthly increase has fallen to 0.13% this year from 0.46% last year. With consumer spending moderating, inflation declining, and rising risks to the labour market, it seems likely the Fed will adopt a dovish stance today, signalling the start of an easing cycle. There’s also speculation that market pressure may push the Fed towards a larger rate cut. If market expectations of a significant cut strengthen, the Fed could deliver it, which would likely drive the dollar lower and potentially push the pound, euro, and yen to multi-year highs.

However, could this be one of the rare meetings where the Fed doesn’t follow market sentiment? Some policymakers may resist such an aggressive move, given that the US economy remains robust, unemployment is low, inflation is above target, and stock markets are at record highs. Therefore, a 25-basis-point cut is still possible, which could limit the dollar's weakness in the short term.

UK Inflation Meets Expectations

UK inflation data for August matched forecasts, with the annual rise in CPI holding steady at 2.2%, exceeding the Bank of England's (BoE) target for a second consecutive month. Core CPI increased to 3.6% from 3.3%, while services CPI, the BoE’s preferred measure, climbed to 5.6% from 5.2%, both in line with expectations. Following the release, the pound strengthened slightly, with GBP/USD trading in the upper $1.31 range and GBP/EUR steady around €1.18.

Given that the data aligned with expectations, and the rise in core and services inflation was largely driven by base effects and volatile hotel prices linked to Taylor Swift’s tour, this is unlikely to have a major impact on the BoE’s upcoming monetary policy decision. The consensus is that policymakers will hold rates at 5%, with markets only pricing in a 25% chance of a rate cut. With wage growth slowing in July and signs of moderating economic activity raising concerns about the UK’s economic outlook, inflation may become less of an issue. We expect the BoE to start its easing cycle in November. However, much will depend on the size of the Fed's rate cut and its forward guidance, which could influence the BoE’s future decisions.

At present, rate differentials favour the pound, with the BoE seen as the least dovish of the G3 central banks over the coming years. However, this assumption could be challenged if the BoE adopts a more dovish stance. Overnight volatility in the pound has risen to its highest since August 2023, as traders position themselves ahead of policy announcements from both the Fed and the BoE.

Euro Unfazed by ZEW Decline

The euro slipped slightly but remains above the key $1.11 level as markets await the outcome of the Federal Reserve meeting, with debate continuing over the likelihood of a larger 50-basis-point rate cut. European stocks and bonds have reversed their earlier trends, with the Stoxx50 equity index gaining nearly 0.7% on the day, while bonds fell, reflecting global market dynamics.

On the economic front, the ZEW Indicator of Economic Sentiment for Germany dropped sharply in September, falling to 3.6, its lowest level since October 2023, from 19.2 in August. The current conditions index also fell to its lowest point since May 2020, dropping to -84.5 from -77.3. Similarly, the Eurozone-wide ZEW measure fell to an 11-month low of 9.3, well below the expected 16.3, highlighting ongoing uncertainty about the economic outlook and the future of monetary policy. Despite these disappointing indicators, the European Central Bank (ECB) is in no hurry to accelerate its easing cycle. Several members of the ECB's Governing Council, including Simkus, have signalled that the December meeting is the most likely time for a third rate cut, with little chance of a cut in October—markets currently price a roughly 30% probability of such a move.

In the options market, sentiment has turned more bullish on the euro ahead of the Fed decision. One-week EUR/USD risk reversals are increasingly skewed towards euro calls, with the spread reaching nearly 0.7 vol—indicating the most bullish outlook for the euro in nearly four years. While a smaller 25-basis-point Fed cut could lead to some profit-taking on the euro, it is more likely to moderate further dollar weakness rather than trigger a significant reversal in the euro’s trajectory.

Pressure builds on the dollar

The US dollar continues to slide as expectations grow for the Federal Reserve to embark on a cycle of monetary easing. Market sentiment is divided on whether the Fed will reduce interest rates by 25 or 50 basis points, with the odds evenly split between the two scenarios. This uncertainty has pulled the yield on two-year US Treasury bonds down towards its lowest point in two years, while the US dollar index has weakened to levels last seen in January.

From an investor’s perspective, the dollar is now considered a less desirable asset due to the uncertainty surrounding the Fed’s decision and the possibility of a substantial rate cut. Consequently, the GBP/USD rate surged to its highest in almost three weeks during Monday’s trading session, rising above $1.32 and gaining over 0.6% so far this week. In the short term, the outlook continues to favour a weaker dollar, particularly as the PCE report due at the end of the month is expected to be soft. This should provide the Fed with the justification to reduce rates further at the next meeting and continue its policy of back-to-back cuts. Traders are, in fact, showing a stronger preference for put options betting on a weaker dollar, rather than calls predicting a stronger one, over the coming week and month.

The upcoming US election in November could add another layer of uncertainty for investors, potentially preventing the dollar from a sharp decline. However, the true driver of the Fed’s policy and the future of the dollar will likely be the labour market. A marked decline in the dollar and a significant shift towards other currencies would most likely occur if recession risks in the US increase, further justifying the aggressive market stance on easing.

Euro buoyed by bets on large Fed rate cuts

The euro began the week of the Federal Reserve meeting on a strong footing, rallying above the $1.11 level and posting gains of over 0.4% on Monday. This upward momentum was largely fuelled by an increase in bets on the likelihood of a half-point rate cut from the Fed. Despite this, sentiment around other euro-denominated assets was mixed, with equities trending downwards while bonds remained in demand.

On the domestic front, Monday’s economic data was limited. Italy’s final inflation figure for August was revised down to 1.2% year-on-year, slightly below the initial estimate of 1.3%. The market’s main attention, however, was on speeches from European Central Bank (ECB) officials. ECB’s Kazimir indicated that no rate cuts are likely at the October meeting, suggesting the bank will stick to its usual quarterly approach. He commented that a clearer economic picture would likely only emerge by December, at which point back-to-back cuts would only be considered if there were “significant developments” in the outlook. Similarly, the ECB’s Chief Economist, Philip Lane, supported a cautious and gradual approach, consistent with previous indications of ECB policy changes.

As a result, the implied probability of an October rate cut, as reflected in the OIS curve, dropped from over 45% on Friday to around 30%. Further adjustments in the short-term outlook are expected as the week unfolds. Nonetheless, markets are still pricing in more pronounced ECB rate cuts by 2025, coinciding with an anticipated slowdown in the Fed’s tightening. In the options market, the 1-week EUR/USD implied volatility has been rising for two consecutive days but remains close to the year’s average. With the Fed’s meeting due tomorrow, volatility is likely to increase further over the next 36 hours as traders prepare for the outcome.

Meanwhile, EUR/GBP remains under pressure, as the Bank of England (BoE) is not expected to change its monetary policy at Thursday’s meeting. This has caused the pair to drop to its lowest level in over a week, near 0.8420. However, the euro could see a lift if UK inflation data, due tomorrow, comes in lower than anticipated, potentially fuelling expectations of dovish action from the BoE.

The Pound Sterling has rebounded against the Euro, supported by improved market sentiment, with the Pound to Euro (GBP/EUR) exchange rate at 1.1860 on Friday. We expect it could rise further, targeting an initial resistance at 1.1882 over the next day or two, provided global equity markets remain positive. The strong correlation between GBP/EUR and the U.S. S&P 500 index has been a key factor in the Pound's midweek recovery, driven by gains in the stock market.

The European Central Bank’s recent decision to cut interest rates had little impact on the Euro, as it was widely anticipated. In fact, the ECB's balanced guidance and updated forecasts have supported the Euro, as they did not signal an accelerated pace of rate cuts. Economists expect the ECB to continue reducing rates gradually, around once per quarter, providing a stable outlook for the Euro and limiting any further upside for the Pound to the 1.1882-1.19 range.

Looking ahead, central bank policy will take centre stage, with next week’s inflation report posing a key risk for the Pound. We see asymmetric risks for Sterling, with the currency likely to be more sensitive to weaker-than-expected inflation data. While markets anticipate the Bank of England will hold interest rates steady next Thursday, a downside surprise in inflation could raise expectations of future rate cuts, which would weigh on the Pound.