The US dollar fell to its weakest level in about four months as traders fully anticipate the Federal Reserve (Fed) will implement an interest rate cut in September. This decline was exacerbated by a significant rally in the Japanese yen, which impacted global currency markets following comments made by Donald Trump regarding foreign exchange (FX) rates.

The Republican presidential nominee, Mr. Trump, stated that the strength of the US dollar has been detrimental to the competitiveness of US exports. He also highlighted that the weakness of the Japanese yen and Chinese yuan provides a trading advantage to Japan and China. This caused a shockwave through FX markets, putting pressure on the dollar and driving the yen sharply higher. The USD/JPY pair dropped over 1%, reaching a new five-week low amid growing concerns about whether short positions on the yen are excessive, especially considering Japanese officials' readiness to intervene and the anticipated interest rate hike by the Bank of Japan at the end of July.

Ultimately, despite Trump's remarks, high tariffs, tax cuts, a weak dollar, and low inflation are an incompatible mix. We are hesitant to predict significant dollar weakness in the second half of this year due to Trump’s inflationary policies, which tend to support the dollar. Nonetheless, the dollar index is now below its 200-day moving average and testing four-month lows.

US Retail Sales Remain Flat in June, Surpassing Expectations

US retail sales held steady in June, outperforming the consensus forecast of a 0.3% decline and matching May's upwardly revised 0.3% increase. Additionally, the core metric saw its largest rise since April of last year, indicating strong consumer spending and buoying equity and USD bulls.

Yesterday, the S&P 500 and Dow Jones reached new record highs as investors analysed key macroeconomic data, monetary policy outlook, and corporate earnings. Money markets are currently anticipating two Federal Reserve rate cuts by the end of the year, beginning in September and likely followed by another in December, with a 65% chance of a November cut as well. Consequently, the recent weakness in the dollar is expected to be short-lived, as the threshold for additional easing has risen due to recent repricing and persistent robust activity indicators, such as the latest retail sales figures. However, it is anticipated that consumer spending will likely remain subdued through the end of the year due to a cooling labour market and slower income growth.

In parallel, increasing odds of a second Trump presidency, following a failed assassination attempt, could provide further support to Treasury yields and the dollar. Trump's policies are perceived as inflationary, which might slow the pace of Fed rate cuts in 2025.

UK Inflation Report Shows Stability, Strengthens Pound

The much-anticipated UK inflation report released this morning revealed that the headline inflation rate remained steady at 2% year-over-year for the second consecutive month. The core inflation rate was reported at 3.5% year-over-year, while the Bank of England’s (BoE) closely watched services inflation stayed unchanged at 5.7% year-over-year. As a result, the market-implied odds of an August rate cut have decreased to 49%, leading to early strength for the pound in European trading hours.

The British pound has been the standout performer in the foreign exchange market this year, appreciating against more than 70% of the 50 global currencies tracked. It has risen nearly 3% against the USD year-to-date and is nearing two-year highs against the euro. Sterling's gains have been supported by high real yields and a stronger economic recovery, as well as optimism surrounding the new Labour government, which has provided stability in contrast to the political uncertainties in France and the US.

Recent hawkish comments from BoE officials, including Chief Economist Huw Pill, align with today’s inflation report, reinforcing their cautious stance on premature rate cuts. With core and services inflation remaining elevated, it is unlikely that the BoE will cut rates next month, which should continue to support the high-yielding pound.

With no BoE speakers scheduled before the 1 August meeting, there are no significant factors expected to undermine the pound’s momentum this week, barring any unexpected downside surprises in CPI data.

Euro Gains Amid Mixed Market Sentiment

The euro gained against high-beta APAC and Scandi G10 currencies as risk-on sentiment cooled, but it was weighed down by a resurgence in the US dollar following an unexpected rise in US retail sales. European equities fell for the second consecutive day, and European bond yields hit multi-week lows, mirroring a decline in US Treasury yields after Federal Reserve Chair Powell's dovish comments earlier this week.

The Eurozone ZEW Indicator of Economic Sentiment fell more than expected to 43.7 in July, against market expectations of 48.1. This marks the tenth consecutive improvement, but the decrease in optimism aligns with concerns about slowing recovery momentum across the bloc. The German equivalent also dropped, marking the first such instance in 2024. The economic outlook is worsening due to falling exports, political uncertainty in France, and unclear future ECB monetary policy. However, the current conditions index rose to its highest level in a year.

The ECB’s Q2 2024 Bank Lending Survey showed a modest improvement in lending conditions, driven by credit demand. The survey indicates that the influence of interest rates on loan demand is diminishing. Despite this, bank credit standards remain tight, and loan demand is expected to stay sluggish throughout the year as policy rates remain restrictive.

EUR/USD declined for the second straight day, with the $1.09 barrier proving unsustainable due to weakening domestic investor sentiment, partly a legacy of the French parliamentary election. We expect the euro to stay supported in the upper $1.08 range amid recent short-term yield spread compression. The euro also fell against the Canadian dollar, as markets focused more on disappointing Eurozone indicators than signs of cooling Canadian inflation, which increases the likelihood of a BoC rate cut next week.

The final Eurozone CPI is due later today, but as no revision is expected, the release should largely go unnoticed.

Odds of Donald Trump winning a second term as president have risen to about 67%, up from 60% prior to the assassination attempt on the former president over the weekend. The market reaction has been relatively muted so far, but the yield on 30-year Treasuries has surpassed that of two-year notes for the first time since January, driven by expectations that Trump’s policies will spur economic growth. Markets are now grappling with the concept of the “Trump Trade,” which reflects the anticipation of a pro-business environment and significant economic boost through fiscal stimulus. This scenario could limit the extent of Fed rate cuts, helping the dollar maintain its high growth and yield advantage. However, we believe US macroeconomic factors could be a more significant driver of the FX market through the summer. Recent data points to easing inflation, a cooling labour market, and moderating consumer spending, raising concerns about a potential abrupt US slowdown and a more dovish Fed, which may weigh on the dollar.

Recent softer economic data, including broad-based weakness in the June CPI, have increased the likelihood of two Fed rate cuts this year. Additionally, the modest decline in manufacturing conditions reported in the New York Fed’s Empire State Manufacturing Survey suggests the ISM Manufacturing PMI for July could also soften. Today’s focus is on US retail sales, which are expected to show a third consecutive month of weak spending due to high borrowing costs and a cooling labour market.

The British pound has pulled back slightly from its highest level in a year against the US dollar, remaining just below the crucial $1.30 mark. Meanwhile, GBP/EUR is hovering around the €1.19 threshold after reaching an almost two-year high yesterday. The next three days will bring critical macroeconomic data that could significantly influence the pound’s recent positive trend.

Currently, the pound appears unusually attractive compared to other currencies, driven by optimism surrounding the new Labour government, in contrast to political uncertainties in France and the US. UK Prime Minister Keir Starmer plans to use the upcoming King’s Speech to highlight his government’s initiatives to boost economic growth. This improving growth outlook is reducing expectations for interest rate cuts, while other countries lean towards easing. Investors now see a 48% chance of a rate cut in August, down from 60% at the beginning of the month. Key UK data releases that could impact the Bank of England’s monetary policy outlook are on the horizon, starting with inflation on Wednesday, labour market data on Thursday, and retail sales on Friday.

A busy week lies ahead, filled with significant data releases, events, and Q3 US earnings reports, all with the potential to move markets.

The ECB is expected to keep interest rates unchanged at Thursday’s meeting but will likely provide further guidance suggesting rate cuts at the September 12 meeting. Financial markets are currently pricing in an additional 45 basis points of rate cuts for 2024.

Next week's economic calendar is dominated by inflation reports from Canada, the UK, the Euro Area, and Japan. Additionally, China's Q2 GDP, UK employment data, and German and Euro Area ZEW sentiment readings will be released. These data points will be spread throughout the week, adding volatility to various FX pairs. If this week’s inflation and wage figures are supportive, we forecast GBP/EUR to reach a target of 1.1985 in the coming days. However, if the data falls short, a decline to our downside target of 1.1768 is possible. Friday’s Retail Sales report is also crucial, with forecasts for June at approximately -0.6%, compared to a solid 2.9% previously. Any positive reading is likely to support Sterling.

Pound Sterling’s strong performance has placed it at the top of the G10 currency basket for 2024, though challenges remain. An overbought Pound will be increasingly vulnerable to disappointing data releases (excluding England’s disappointing performance against Spain!).

Across the pond, The week has begun with a stronger US dollar, driven by the renewed "Trump trade" following Saturday's assassination attempt on the former president. This development increases the likelihood of a Trump victory, and his proposed tax cuts and trade tariffs, which are viewed as inflationary, may compel the Federal Reserve (Fed) to maintain high US interest rates for a longer period.