The US dollar is set for its second consecutive quarter of gains, driven by high inflation-adjusted yields, a robust US economy, and safe haven flows amid political instability in Europe. While these factors support the dollar's strength, significant further gains may be challenging if weak macroeconomic data continues to emerge, increasing downside risks.

In the current low volatility environment, "carry trades" remain popular. This strategy profits from interest rate differentials by borrowing or shorting a low-interest-rate currency to fund or buy a higher-interest-rate currency. The Bank of Japan is in no rush to raise interest rates, keeping its inflation-adjusted rates in negative territory and making the yen a favoured funding currency. In contrast, the US Fed has kept the target range for federal funds steady at 5.25%-5.50% for seven consecutive meetings, with no rate cuts expected until there's more confidence that inflation is moving towards 2%.

In the short term, attention is on Friday's core PCE deflator, the Fed's preferred inflation measure, which is expected to show its slowest monthly increase this year. Rate swaps indicate a 70% chance of a Fed rate cut in September. If inflation is lower than expected, it could prompt a dovish market reaction, potentially weakening the dollar.

The opposition Labour Party maintains a substantial double-digit lead in the polls as the UK election approaches, now just over a week away. Markets generally favor continuity, but Labour's shift to a more pro-business, centrist stance and potential closer ties with the European Union could help reduce the pound's so-called Brexit risk premium. As a result, financial markets remain relatively calm despite the approaching election.

A significant Labour majority seems likely, and investors are increasingly confident that such an outcome would signal a more stable political and fiscal environment for the UK. This contrasts with the growing instability risk in France as it heads into its first-round vote on Sunday. Consequently, despite rate differentials suggesting GBP/EUR should be trading lower, the pound has hit new 22-month highs against the euro and may continue to rise in the short term. GBP/USD has remained above its 50- and 100-day moving averages since the election was called in late May, mostly fluctuating within a $1.26-$1.28 range. Monetary policy has been a major driver of FX trends, which is why GBP/JPY has reached fresh 16-year highs above ¥202, supported by real rate differentials favouring sterling and disadvantaging the low-yielding yen.

From a sentiment perspective, the latest CFTC data shows net long GBP positions held by leveraged funds reached their highest level since September in the week leading up to June 18. This is a bullish sign ahead of the UK vote, but it also increases the risk of profit-taking post-election. Therefore, sterling could weaken after the vote, particularly against currencies like the yen, where overbought signals are evident.

The euro’s strong start to the week was followed by bearish trading due to hawkish comments from Fed's Bowman, which reignited demand for the US dollar. Quarter-end portfolio rebalancing added to the volatility in spot markets, though realized volatility remains low as markets await Friday’s US PCE release.

Domestically, the only surprise was an upward revision in Spain's Q1 GDP, which grew by 0.8%, surpassing the preliminary estimate of 0.7%. This marks the strongest growth rate since Q2 2022 for Europe's sixth-largest economy. Meanwhile, spreads on French bonds decreased from their highest level in over a decade, suggesting that investors are less worried about potential disruptions from the upcoming snap parliamentary elections. The OAT-bund spread narrowed to 75 basis points for the first time in a week but remains 1.5 times higher than the pre-announcement level. The 1-week implied volatility on EUR/USD rose to nearly 8 vol at the start of the week, now factoring in the first round of the French legislative elections. This marks the highest expected volatility, excluding the snap election announcement date, since early January and the widest spread versus realized volatility since March 2023.

Despite expectations of larger spot swings, the euro may remain exposed and range-bound until after the second round of France’s elections on July 7, which could significantly influence the currency. The euro has declined over 1% against the Swiss franc and just over 1.8% against the Norwegian krone compared to its level before the European parliamentary elections. Volatility expectations are focused on shorter-term maturities, leading to an inverse implied volatility term structure for EUR/USD, indicating that the premium for French political uncertainty is expected to fade.

At the beginning of the last week of June, US equities showed mixed performance, bonds remained steady, and the recent rally of the US dollar paused. The dollar index retreated from over two-month highs, while the Swiss franc experienced selling pressure, indicating a modest renewal of risk appetite in the foreign exchange market. Attention is now on US consumer confidence data, set to be released later today.

In recent weeks, the US dollar has become the preferred hedge against political uncertainty following the announcement of a snap election in France, which has also increased volatility in European bond markets. This preference was particularly pronounced due to the limited gains of Europe's natural safe-haven, the Swiss franc, affected by the dovish stance of the Swiss National Bank, which cut interest rates for the second time this year. In contrast, the US Federal Reserve has indicated plans for just one rate cut this year, although markets are anticipating almost two cuts, with a more than 60% probability of a move in September. This perceived hawkishness from the Fed has supported the demand for dollars in recent weeks. However, market participants are now awaiting comments from several Fed officials and upcoming data to further evaluate the monetary policy outlook. The core PCE deflator, the Fed’s preferred inflation measure, is expected to be the highlight at the end of the week, likely printing at its slowest monthly pace this year.

Therefore, short-term downside risk for the US dollar might increase if the core PCE data meets or falls below expectations. Despite this, the elevated European risk premium ahead of the French vote on Sunday may limit the upside for European currencies against the US dollar. The USD/JPY pair remains a key focus, with the potential for significant price swings as it hovers near the ¥160 level.

Thanks to a broadly weaker US dollar and a positive UK business survey, GBP/USD is climbing back toward $1.27, rebounding off its 50- and 100-day moving averages. However, the pair is still trapped in a short-term descending trend channel for the month. Meanwhile, GBP/EUR continues to defy real rate differentials, maintaining a position above €1.18 for its longest stretch since 2022.

The euro rebounded from its lower Bollinger band, marking its first daily gain against the US dollar in the past three trading sessions, and approached the key $1.0750 level, a threshold it had struggled to confidently surpass since the snap election announcement in France. European stocks rose, while government bond yields generally trended lower.

Sterling reached a 22-month high against the Euro this month, but since then, its performance has weakened, and the GBP/EUR exchange rate has dropped to around 1.1820, where it stands at the start of this week.

There are no major data releases expected from the Eurozone this week, leading us to anticipate a gentle pullback and consolidation. It wouldn’t be surprising to see the rate test 1.18. Nevertheless, the Pound is still in a broader uptrend, with key technical indicators remaining supportive, suggesting that any weakness should be limited.

This outlook is influenced by political risks impacting the Euro, particularly due to the French legislative elections. Forward-looking financial products indicate potential volatility during the election period, with polls suggesting a 'hung' parliament. This scenario, while not the worst, is less than ideal for France, given its significant debt and investor concerns about the country's financial outlook.

Meanwhile, GBP/USD is trading near 1.2650 in the European morning on Monday. The policy divergence between the Bank of England and the Federal Reserve undermines the pair, while a stable risk tone limits any downside. The focus now shifts to speeches from Fed policymakers, with the UK and US data calendar being relatively quiet.

Last Thursday, GBP/USD dropped by 0.5% and continued to decline during the early European session on Friday, touching its lowest level since mid-May at 1.2630 before edging higher to the 1.2650 area. The technical outlook does not indicate a strong recovery momentum.

Looking ahead to the weekend, market participants will watch the latest US and UK GDP numbers, released Thursday and Friday respectively. Both the annualised and quarterly print for the UK are expected to show significant improvement versus the previous print, with YoY reversing into the green at 0.2 percent. Meanwhile the quarterly figure should rebound to an impressive 0.6 percent.

The Bank of England (BoE) voted 7-2 to maintain rates at 5.25% for another month. As anticipated, the meeting had little immediate impact, with GBP/USD and GBP/EUR slipping by less than 0.4%, despite the likelihood of an August rate cut increasing from 30% to over 60%. This morning, sterling remains steady, unaffected by stronger-than-expected UK retail sales and the highest consumer confidence in over two years.

Key insights from the BoE’s statement and meeting minutes indicated a "finely balanced" decision not to cut rates, highlighting divisions among the majority about the significance of unexpectedly strong services inflation. This announcement followed data showing UK inflation had reached the central bank’s 2% target for the first time in almost three years, although the services sector inflation slowed less than anticipated. Some policymakers, despite voting to keep rates unchanged, noted that surprises in services inflation hadn't altered the economy's disinflationary path. This was perceived as dovish, leading to a slight decline in UK gilt yields and the British pound.

Sterling remains surprisingly resilient, even though it appears overvalued compared to swap differentials, particularly against the EUR and USD. This resilience might be attributed to factors beyond cyclical and monetary policy considerations, such as the prospect of more stable UK politics and improved UK-EU relations under a potential Labour Party leadership, which could act as a bullish factor.

The US dollar has experienced a relatively calm period recently, despite US yields hitting a two-month low. The dollar faced mild selling pressure as US retail sales for May rose less than expected, reinforcing a 60% probability of a Fed rate cut in September. However, dovish policy signals from Europe are helping to keep the dollar stable. Today, attention shifts to flash industry PMIs from Europe, the UK, and the US, offering an initial look at economic activity deviations for June.

Yesterday's data releases included the Philly Fed survey, jobless claims, and housing starts, all of which came in slightly weaker than expected. Despite this, US Treasury yields edged up slightly, supporting the dollar against most major currencies. Recent hawkish comments from the Federal Reserve, in contrast to its major peers, are keeping the dollar on track for its third consecutive weekly rise. Notable gains have been made against the Swiss franc, which came under selling pressure after the Swiss National Bank cut interest rates for the second time this year. The Japanese yen is also drawing attention, with verbal intervention anticipated as it trades around 158.90 per dollar, close to the significant 160 per dollar level. Meanwhile, the US has added Japan to its “monitoring list” for foreign-exchange practices but stopped short of labelling it a currency manipulator.