The worsening economic data out of the Eurozone didn’t help, but what finally did the euro in last week was a surprisingly dovish European Central Bank meeting. At its meeting last week, the ECB raised rates as expected, although surprisingly hinted that this could be the final one in the current tightening cycle. The euro had been wobbly all week, but the prospect of rates peaking below 4%, without any clear signs that core inflation is trending down, sent the currency reeling. Most G10 currencies followed the euro down against the dollar, despite the likelihood that last week’s rate hike from the Federal Reserve was the last. Emerging market currencies withstood the dollar rally very well, and the week’s performance table was headed by the South African rand, the Mexican peso and the Brazilian real. The latter two added to their scorching performance so far this year.
This week will be data packed. On Monday, we’ll receive the Eurozone second-quarter GDP growth and July flash inflation reports. It will be key to see whether these two validate the ECB dovish turn – should core inflation surprise to the upside, things could get interesting in FX markets. The Bank of England meets on Thursday. Friday is payrolls day in the US, a key data point that comes after a run of positive economic surprises in the US that speak to the surprising resilience of the American economy in spite of higher rates. August is traditionally a quiet trading month in FX markets, but 2023 could easily prove the exception given the accumulation of uncertainties.
Sterling reacted surprisingly well to the poor PMIs of business activity published last week. However, a gap is developing between these business surveys and actual economic data, which continues to show resilience and is consistent with a tight labour market and plenty of consumer firepower. Expectations for the Bank of England meeting this week have cooled ever since the recent positive surprise on inflation, although markets are still pricing in a small chance of a 50bp hike, with the certainty that we will get at least a 25bp one. As usual, the key to the reaction in the pound will be the voting pattern among MPC members. We are eying a three-way split vote, whereby at least one member (Dhingra) votes in favour of no change, while a handful, though not enough for a majority, potentially side with a 50bp hike. Either way, the pound continues to trade strongly and is now back as the best performing G10 currency of 2023.
Dismal sentiment in the manufacturing sector dragged down the PMI surveys to a level consistent with a recession. This no doubt weighed on the minds of ECB members, which decided to hike rates as expected, but made it clear that the September meeting was wide open. Lagarde’s tone in the press conference reinforced the sense of caution, and she explicitly indicated that the bank was open to pausing the tightening cycle at the next meeting in September. We think that this is now the mostly likely option, with a final hike possible in October, should data warrant. The prospect of a terminal rate of not even 4% sent the euro sharply lower. The ECB seems to be betting that inflation is a lagging indicator that cannot fail to come down given weakness in the economy and the disinflationary trend clearly visible in the US and most emerging markets. Monday’s flash inflation numbers will provide a key test of this view.
The Federal Reserve hiked rates again last week and left the door open to additional rate increases, although only if the incoming data warrants it. Powell’s communications suggest that the FOMC is very much taking a wait-and-see approach and will assess upcoming inflation and jobs market reports before deciding whether another rate hike is necessary before the end of the year. With inflation seemingly on the way down, this could well mean that the hiking cycle is over, but the US economy continues to outperform expectations and the hot labour market refuses to budge. Last week’s GDP number surprised to the upside, led by a surge in business investment. This week’s labour market report is expected to show a still tight jobs market with unemployment well below 4% and wage rises finally outpacing inflation. The contrast with the stagnating European economy may prevent EUR/USD from continuing its 2023 rally in the short-term.