Market Rebound Continues Amid Easing Volatility and Focus on US Jobless Claims

Equities have continued their rebound, cryptocurrencies have surged higher, and the US dollar is grappling with pro-cyclical foreign exchange as the recent financial panic subsides. This renewed risk appetite is supported by a modest decrease in volatility, though the VIX "fear index" remains significantly above its long-term average. Today's focus is on the weekly US jobless claims figures, following last week's sharp slowdown in payroll growth and rise in unemployment, which heightened recession concerns.

On Monday, our financial sentiment index turned negative for the first time this year due to the flight to safety, increased demand for downside protection, and spike in market volatility. This shift has provided some support for the US dollar against its pro-cyclical counterparts. However, with US economic growth weakening and the Federal Reserve expected to begin its easing cycle in September, we anticipate further dollar depreciation in the medium term. The extent of this decline will depend on the global growth outlook and US political developments.

Traders are speculating that the Fed might start its loosening with a larger-than-average 50-basis point cut in September, but significant deterioration in the labor market would be necessary for such an aggressive move. Unless next week's US CPI data presents a surprise, the attractiveness of USD rates appears diminished, and if the dollar index falls below 102, the psychological threshold of 100 could be within reach.

Sterling Struggles Amid Market Calm, Needs Fresh Catalyst for Revival

Despite the dust settling after the market turmoil at the start of the week, sterling continues to struggle against its major peers. GBP/USD is flirting near key moving average support levels on the daily chart, around $1.27, while GBP/EUR is edging closer to €1.16, primed for another 1% weekly decline. It's clear sterling needs a fresh positive catalyst to resume its climb from the first half of 2024.

Revised UK GDP data wasn’t such a catalyst. It turns out that 2022 was better than statisticians thought, as UK GDP jumped 4.8%, instead of the 4.3% previously estimated, according to annual revisions. The data suggest the economy was showing underlying resilience even as it began to be roiled by Russia’s invasion of Ukraine, which sent inflation in Britain surging to a peak of 11.1% in October 2022. The impact of the cost-of-living crisis later triggered a recession and slowed annual GDP growth to just 0.1% in 2023. However, the economy has bounced back more quickly than many forecasters had expected this year as the surge in inflation fades.

The Bank of England’s (BoE) interest rate cut, coupled with the fall in inflation, has reduced the pound’s real yield appeal. Additionally, speculative positioning was heavily stretched in favour of sterling bulls coming into the second half of the year. Hence, the bullish drivers of sterling strength have weakened of late, but we think a sustained improvement in global market risk appetite should act as a welcome relief for the UK currency alongside the brighter UK growth outlook.

Improved Market Sentiment Boosts European Equities and Stabilises EUR/USD

Market sentiment improved further on Wednesday, with European equities climbing higher and Bund yields recovering to pre-NFP levels. Bunds edged lower for a third day as investors continued to unwind haven buying, and the EUR/USD spot rate remained largely stable around Wednesday’s open rate of $1.083.

Bund yields are likely to continue trading in lower ranges as European Central Bank (ECB) and Federal Reserve (Fed) rate cuts are anticipated. In the Eurozone, the market’s assessment of recession risk remains elevated, as incoming data does not show a marked improvement. Yesterday’s macro data from Germany showed a sharp fall in exports, which was counteracted by better-than-expected industrial production growth in June. This suggests that while the export-oriented growth model is fundamentally struggling, there could still be a small cyclical improvement in the second half of the year.

With assistance from soothing comments by the Bank of Japan, the euro rallied against the safe haven currencies JPY and CHF by more than 1.4% but continues to trade lower compared to a week ago. Having rallied close to 2% over the past five days, EUR/GBP has eased from near three-month highs and is now below the £0.86 level. Money markets continue to trim ECB rate-cut bets, pricing in 68bps of easing by year-end compared to 71bps the day prior. Investors are more hesitant to price out Fed easing at the same pace, thus maintaining EUR/USD relatively supported for now.

With the domestic calendar empty, the only key risk event is the US initial jobless claims. We can expect volatility following the release of this report, as market participants will be looking for data to support or disprove the belief that the US labour market is slowing faster than the Fed expects, thereby justifying the current OIS curve pricing.

Asian Markets Rebound and Yen Weakens Amid BoJ Comments

Asian stocks have rebounded overnight, and the Japanese yen has weakened more than 2% against major peers like the US dollar and British pound. This shift follows comments from Bank of Japan’s (BoJ) Uchida, who raised concerns about the recent volatile market moves and alleviated rate-hike anxiety with dovish remarks. The yen’s slump is being welcomed as it reduces the potential for fresh, rapid carry trade unwinds and the resulting deleveraging impulse across the broader financial system.

Nevertheless, the recent unwinding in carry trades could have more room to run, as the yen remains one of the most undervalued currencies. This trade has been pummeled over the past month, particularly in the past week, leading to the yen’s realized volatility spiking to its highest level since the pandemic. The significant shift in trading activity was exacerbated by the BoJ’s rate hike last week and growing fears of a looming US recession. However, the Federal Reserve (Fed) Bank of San Francisco President Mary Daly helped soothe recession concerns by stopping short of concluding that the labour market has begun seriously weakening. Other Fed officials, who have spoken since the release of the dismal US jobs data from July, have also cautioned against reading too much into one employment report.

Global risk appetite has since improved, with the Nikkei rebounding 2.8%, nearly returning to its position before Monday’s 13% crash. Euro Stoxx 50 futures have advanced 1.3%, alongside gains in US futures. Treasuries have fallen along with safe-haven currencies like the Japanese yen and Swiss franc. The US dollar index has bounced from 6-month lows due to gains against the yen, but it remains softer against pro-cyclical currencies – a pattern that may persist now that the dollar’s rate advantage has been trimmed with four Fed cuts priced in for 2024.

British Pound Declines Amid Reduced Rate Expectations and Carry Trade Unwinds

After trading near €1.20 just a few weeks ago, the British pound has now dipped to just above €1.16 against the euro, falling below key daily moving averages. This decline has reversed much of its year-to-date rally, in line with decreasing expectations for UK interest rates and the unwinding of carry trades, which has negatively impacted global risk sentiment.

Despite the somewhat hawkish Bank of England (BoE) rate cut last week and assurances from Governor Andrew Bailey and Chief Economist Huw Pill that further rate cuts are likely some months away, markets are pricing in another 42 basis points worth of easing before year-end. The rate differentials had already suggested that sterling was overstretched, particularly against the euro, making the GBP/EUR decline unsurprising. The upcoming UK inflation data for July, set to be released next Wednesday, will influence the timing of the next rate cut, although the BoE expects inflation to rise to 2.75% by year-end and has stated it won't react to a single month's data surprises. This outlook likely rules out a rate cut in September, despite markets currently pricing a 47% chance of one.

Heightened global growth concerns and a sharp global equity market sell-off have further complicated the outlook. If the BoE adopts a more dovish stance in the coming months, sterling’s upside potential could be limited before year-end. In the shorter term, considering GBP/USD, August has historically been the pair’s weakest month of the year, with average returns of around -0.80% since 2000.

German Bond Yields Rise as Risk Appetite Returns, EUR/USD Declines

German bond yields moved mostly higher across the curve, lagging behind US Treasuries, as risk appetite returned following a sharp selloff at the start of the week. European stocks, apart from the French CAC 40, climbed as dip buyers emerged. Consequently, EUR/USD surrendered a portion of its recent gains amid soft mean-reverting behaviour. While volatility is noticeably lower, further flare-ups, especially around US labour market reports, cannot be ruled out.

Investors have aggressively priced in an increased risk of a US recession following last Friday’s labour market report, whereas the outlook in Europe remains less clear. Eurozone retail sales fell 0.3% MoM in June, more than the expected 0.1% decrease, driven by a marked decline in sales of food, drinks, and tobacco products. The HCOB construction PMI edged down to a six-month low in July, with activity and output declining significantly, particularly in housing. New business also fell amid weak demand, sparking further job shedding. However, German factory orders rose by 3.9% MoM in June, surpassing market forecasts of 0.8%, marking the first increase since last December. Foreign orders gained 0.4%, with orders from outside the Eurozone rising 0.9%, while orders from within the bloc fell 0.3%.

ECB officials must balance the growth picture in Spain and Italy, which are proving more resilient than Germany. Money markets are betting on the ECB cutting rates by 24 basis points in September and pricing in around 72 basis points by year-end. With relatively stable ECB rate expectations, recent volatility stemmed from the aggregate repricing of Fed easing. As the US rate moves appear exaggerated and are already correcting, scaling back Fed easing expectations suggests some upside risks for the greenback, albeit at a structurally lower level compared to last week.

Smooth Sailing After the Storm?

In just three weeks, approximately $6.4 trillion has been wiped from global stock markets due to rising fears of a US recession, disappointing AI-driven earnings from Big Tech, and a significant unwind of carry trades, leading to a more than 10% appreciation of the Japanese yen. The US dollar showed mixed performance, benefiting from safe-haven flows yet weighed down by concerns over weaker growth and high-yield appeal.

Deutsche Bank’s FX Volatility Indicator shows currency volatility has surged to levels last seen in October 2023, exceeding its 5-year average. Despite this, broader financial markets are showing signs of stabilizing today. Japanese equities have rebounded, leading gains in Asia as they recover some of the 12% losses from Monday’s global rout. Additionally, Euro Stoxx 50 futures and US equity futures have advanced, while Treasury yields have fallen. 

In the Treasury market, heightened demand pushed two-year yields, which are sensitive to monetary policy, below those of the 10-year note for the first time in two years. This briefly caused the US yield curve to turn positive for the first time since July 2022, after being inverted for a record duration. Typically, the yield curve steepens back above zero around the onset of an economic slowdown. However, both yields and equities recouped some losses yesterday afternoon after the US ISM services PMI exceeded expectations, driven by a rebound in new orders and the first rise in employment in six months.

Consequently, an off-cycle rate cut by the Federal Reserve appears even less likely. It seems more prudent for policymakers to wait until the September meeting to implement a 25 or even 50 basis point easing, depending on incoming data. Nonetheless, market nervousness might keep the US dollar strong, particularly against emerging market currencies.

Pound Steadies Alongside Equities

Thanks to stabilising equity markets and improving risk sentiment following Monday’s turmoil, the British pound has maintained its grip on the $1.27 support level against the US dollar, staying above key moving averages. Further bolstering sterling, UK retail sales rose 0.3% on a like-for-like basis in July compared to a year ago, reversing a 0.5% decline in June and aligning with market expectations.

This return to growth was largely driven by consumer purchases of clothing and beauty products in preparation for the holidays, as the late arrival of British sunshine boosted spending. Additionally, the final services PMI for July was revised slightly higher, marking the ninth consecutive month of expansion in the UK services sector. These recent improvements in economic activity coincided with the Bank of England beginning to cut interest rates, raising expectations for stronger underlying spending growth in the second half of the year.

While this should support the British pound in the longer term, rate differentials suggest sterling might be overstretched, especially against the euro. As a result, it's not surprising to see GBP/EUR stuck below €1.17, with the pair having dropped over 2% in just a few trading sessions.

Euro has finally found support

The euro has found support from a softer US outlook, rallying to an 8-month high amid safe-haven and positioning unwind flows. Although the pair briefly surpassed the $1.10 threshold, it quickly lost momentum following a better-than-expected US ISM report. This rally has reduced the euro’s year-to-date losses to approximately 0.7%, making it the second-best performer among G10 currencies, just behind the GBP. If the US soft landing scenario faces further skepticism, the euro could climb higher. However, the rally is unlikely to be sustained as weaker global growth does not favour the pro-cyclical euro.

The global stock correction has triggered a rush into Treasuries and European bonds. German 2-year yields dropped almost 20bps in early Monday trading, marking the most aggressive European bond rally since the French snap election announcement. The German front end is trading as though the European Central Bank is poised to cut interest rates imminently. At one point, traders were betting on as many as 42bps of ECB cuts in September and 94bps of cuts by year-end. Rate cut expectations have since stabilized to Friday’s levels, with 26bps anticipated for September 2024 and 77bps by December 2024. The BTP-bund and OAT-bund spreads widened by 7bps and 4bps, respectively, as fears of a global recession grow.

Elsewhere, the euro remains under pressure from safe-haven flows. EUR/CHF depreciated for the sixth consecutive day amid risk-off sentiment, pushing the spot rate near 2024 lows. The euro also posted another single-digit loss against the Japanese yen due to the continued unwind of short yen positions. The options market shows clear signs of heightened market stress. All G10 euro crosses exhibit an inverted implied volatility term structure, with implied volatility for tenures up to 4 months exceeding those on longer tenures. EUR/JPY implied volatility structure is now entirely in backwardation. EUR/USD 1-week risk reversal saw the sharpest single-day bullish repricing in two years last Friday, with the skew currently at 0.373 vol in favour of calls.

Last week, GBP's high sensitivity to risk asset performance was evident despite a relatively hawkish first rate cut by the Bank of England (BoE). GBP/USD is struggling to maintain its $1.27 support level, while GBP/EUR has fallen below €1.17 at interbank for the first time since May. However, the Japanese yen is the real standout, with GBP/JPY plummeting 13% since mid-July, including a 10% drop in just the past week, erasing all its year-to-date gains within weeks.

Markets had priced in a 60% chance of a BoE rate cut to 5%, and the BoE’s Monetary Policy Committee (MPC) voted 5-4 in favour of the cut last Thursday. Although a hawkish tone initially limited GBP's losses, gilt yields dropped to fresh one-year lows, and markets began anticipating more rate cuts by the BoE this year.

The EUR surged past the $1.09 mark on Monday as weak US NFPs and a higher US unemployment rate shook the markets. Meanwhile, EUR/JPY saw its worst monthly decline in eight years (-5.8%), and EUR/GBP fell for the fifth consecutive month in July, the worst streak since January 2020. Despite this poor performance, the EUR rallied to a one-month high by the end of the week, a delayed reaction to the BoE’s hawkish decision last Thursday.

This week’s economic calendar is light, with key items including final PMIs, Sentix Investor Confidence, German factory orders, and European retail sales. As we enter a seasonally quiet period for both data and ECB speakers, this could be beneficial for the EUR. The EUR has shown a strong positive correlation with a decrease in realised FX volatility, which may help support it during this lull in activity.