ECB set to cut rates despite stalling disinflation

Highlights:

– ECB set to cut interest rates for first time, despite stalling disinflation trend.

– US PCE inflation report meets expectations ahead of May payrolls data.

– JPY rebounds after hawkish BoJ comments raise rate hike bets.

– CAD underperforms peers on soft GDP report. Bank of Canada seen lowering rates on Wednesday.

The next couple of weeks of FX trading look set to be among the most eventful for some time, following possibly the least lively weeks of the year in the G10 – the quiet before the storm?

Data and policy decisions were scarce to non-existent last week, and recent tight ranges held in G10 currencies. Yet another upward surprise in Eurozone inflation was enough for the euro to erase its weekly losses against the dollar, but no more, as markets await clarification on the policy stance of the European Central Bank after this week’s all but guaranteed interest rate cut.

We expect the next two weeks to be the opposite from the previous two. The ECB’s June meeting will open the month, followed the next day by the May labour report out of the US and then the US inflation report early next week. In addition, markets will deal with the post election fall out in South Africa, Mexico and India. As always, inflation data in Europe and the US, and central bankers reaction to them, remain key. The relentless push back against market hopes that significant cuts were coming in 2024 has not been kind to high risk currencies in general, and emerging market ones in particular.

USD

Last week’s PCE inflation report for April, the Federal Reserve’s preferred measure of price pressures, came out exactly as expected and a touch softer than the CPI report published earlier in the month. This was enough to deflate the week’s rise in US interest rates and bring them back to unchanged for the week, in the process pushing the dollar down towards similar levels. Indeed, the dollar ended May lower against most of its major peers, aside from the yen, with generally stronger global economic data, particularly out of Europe and China, buoying risk sentiment at the expense of the safe-havens.

This week should be a lot more interesting, with the nonfarm payrolls report on Friday dominating a busy calendar. In addition to the headline net job creation number, markets will be focused on the monthly wage increases, to see if sticky services inflation is translating into bolder pay demands among workers.

EUR

The European Central Bank will almost certainly cut interest rates on Thursday by 25 basis points. Markets are in almost universal agreement on this point, with swaps almost fully pricing in an immediate cut. The key, however, will be the extent and timing of any subsequent cuts, and both of these have been pushed back relentlessly over the last few weeks.

Last week’s May inflation data again came out higher than expected, and it seems clear that the disniflation trend has at least stalled. Particularly concerning is the rebound in pricing pressures in the services sector, driven by rising labour costs and consumer demand. There is real uncertainty over what ECB officials make of these trends, and Thursday’s post meeting press conference is shaping up to be the key event of the week in currency markets.

GBP

Sterling is holding up surprisingly well in spite of the election announcement and some tentative signs of cooling in the services sector in the latest PMIs, and fragility in consumer spending in the most recent retail sales report. Indeed, the pound continues to comfortably outperform the euro in the past month, as markets view a Labour majority as perhaps the most market-friendly outcome of the pending general election – a reflection of both the lingering damage done by Liz Truss’ ill-fated budget, and a shift towards the political center under Keir Starmer’s leadership.

Data this week is quite light, dominated by surveys rather than hard numbers. The Monetary Policy Committee of the Bank of England has suspended all communications except the actual June meeting in view of the 4th July election. This means there will be little idiosyncratic factors to guide the pound in markets and it will largely trade off events elsewhere.