Dollar sinks as European political worries ease

Political fears eased last week as markets became less apprehensive about the French polls, sending risk assets and the euro up and the dollar down.

Highlights:

Political risk premium in Europe is reduced but uncertainty remains after the 2nd round of voting in France.

Dollar sells-off against all peers as economic data disappoints and risk sentiment improves.

Speculation grows that Harris may replace Biden in a US presidential race.

Labour won landslide victory in the UK election. GBP ignored the results.

Safe-havens and CAD underperform.

The surprise victory by the left in the French National Assembly elections, however, has had little impact on markets so far. Investors seem to balance optimism about the National Front’s defeat with worries about the leftist first place, leaving the euro largely unchanged from Friday’s close, but significantly higher from the levels just after the calling of the election. More generally, dissipating political risk premia and continued softness in US economic data sent almost every major world currency higher against the US dollar.

Political uncertainty in the US about Biden’s candidacy has yet to have a significant market impact. Focus will now shift to political horse-trading in the hung French Assembly, where right, left and centre are all very far from the numbers needed to govern. Attention on the economic front will shift from the apparent slowdown in US economic data to US inflation, as the June report is published on Thursday. Economists optimistically predict another 0.2% monthly increase in the core index that would signal a return to normality and the Fed’s inflation targets and allow the central bank to begin rate cuts after the summer.

USD

It’s perhaps a little too soon for FX markets to start pricing in the increased likelihood of a Trump victory in November, so the hints of softening in US economic data are driving markets. The payroll report for June contained more hints of a slowdown, as unemployment ticked up to 4.1%, prior job creation data was revised down, and wage growth slowed.

The data is not yet conclusive but together with the expected slowdown in June inflation does seem to free the Federal Reserve to cut rates twice in 2024, starting in September. If so, we would expect the dollar to give up some of its 2024 gains before the end of the year.

EUR

The common currency drifted higher all week in response to softer US labour data and hopes for a hung French assembly that would deny both far right and far left power. As for the latter, the actual results seem to have validated expectations, but the stronger-than-expected showing by the left may cap the euro rally in the short term.

Domestic data had little impact on the common currency in recent days. A slightly more persistent than expected core inflation, which stabilised at 2.9%, does not change the overall picture significantly, with both markets and us pencilling in two ECB rate cuts before year-end. The economic and policy calendar in the Eurozone is sparse next week, so look for the euro to trade largely in reaction to French political headlines and the US inflation numbers on Thursday.

GBP

The widely expected huge Labour majority in the general election has been priced in by markets and had little visible impact on the pound. It must be noted that the UK first past-the-post voting amplified its margin of victory, which in percentage terms was considerably smaller than what has been expected.

Attention now shifts back to the economy, with a slew of May data out on Wednesday, including industrial production and monthly GDP. Bank of England policymakers will also be speaking for the first time since the June meeting.