Investors flee to the dollar as elections and politics drive markets

Highlights:

Euro struggles as French election uncertainty adds unwanted political risk premium.

US inflation misses expectations, but FOMC signals only one rate cut ahead in 2024.

Bank of England set to keep rates unchanged but could indicate first cut on the horizon.

We got a hint a couple of weeks ago about the renewed importance of the political calendars after election results in Mexico, South Africa and India rocked those countries’ markets and currencies – last week, the turmoil moved to Europe.

Deep uncertainty over the outcome of the snap French parliamentary elections rocked European assets and currencies, with the euro and French government bonds and stocks leading the way down. Politics are taking centre stage, and even the good news of softer than expected US inflation earlier in last week, and the consequent drop-in US treasury rates, was not enough to help European currencies. In yet another example of the primacy of politics, the best performing currency of the week was the South African rand, buoyed by news of a market-friendly agreement between the ANC and the centrist Democratic Alliance.

This week’s data is relatively light, with mostly the worldwide PMIs of business activity on tap, and those are not out until Friday. More important for the euro will be the headlines about polls and possible alliances coming from France, as markets hope that Macron’s centrist allies can prevent outright majorities by either the Right or the Left. The key monetary policy event will be the Bank of England’s June meeting, where no change is expected, and markets will be focused on the forward guidance given by the Monetary Policy Committee about the timing of the first cut.

USD

A much-welcome soft US inflation report for May on Wednesday contrasted with a relatively hawkish Fed announcement just hours later. The “dot plot” suggested that most FOMC officials now see room for just one cut between now and year-end, a downgrade from the three pencilled in back in March. This was somewhat of a hawkish surprise, particularly following the miss in the May CPI data, with most of the market expecting the 2024 median dot to show a total of two cuts this year.

In his press conference, Chair Powell emphasised that everything still depends on future labour and inflation data prints, and there actually appears a fine balance between the hawks and the doves in the committee, suggesting that our baseline scenario for two cuts in September and December remains in play. This week, the political turmoil in France will steal the spotlight from the US dollar, but retail sales and the PMIs will still provide an important read on the extent to which US demand is slowing down.

EUR

The more markets look into the potential outcomes for the French assembly elections of 30th June, the less they like it. In addition to the uncertainty surrounding the likelihood of a hung parliament, there is the chance that Macron’s majority will be replaced by a right- or left-wing one that will undo his reforms, increasing spending, and leading to more hostility to the European project. French bond spreads shot up relative to Germany ones to levels not seen since the euro crisis over a decade ago, and European risk assets tumbled even as the US stock market continued printing fresh record highs.

This week’s PMIs are expected to show continued improvement consistent with modest economic growth. Activity data out of the common bloc has largely surprised to the upside since the start of the year, and markets will be looking for much of the same this week, particularly in the services index. This data will, however, likely be overshadowed by political news from France and investors’ reactions to it.

GBP

The Bank of England will have to weigh recent contradictory signals from the UK economy at its policy meeting on Thursday. On the one hand, the May employment report showed clear signs of a slackening in the labour market, with both the unemployment rate and the claimant count of jobless claim benefits rising more than anticipated. On the other hand, the upside surprise in April inflation, particularly in its services component, and stubbornly high wage pressures, which continue to print at around 6% on an annual basis, argues for a delay in the start of the cutting cycle.

The May inflation report will be released one day before the MPC meets, which only adds to the uncertainty. Further signs of disinflation here could be enough to trigger for a dovish shift in the bank’s communications, which potentially paves the way for an August cut. The UK election, however, is making little difference to assets, as a large Labour majority has been priced in from the beginning.