The UK Sways

The macro point

Spotlight on the pound sterling! The options market is betting on a decline of the British currency, both against the US dollar and the euro. There are two reasons for this. The UK budget situation is worrying. At the beginning of July, amid a political crisis, UK government bonds collapsed with a sharp and unexpected rise in 10-year rates similar to the turbulence of the Liz Truss era. The pound sterling did not lag behind. For example, it fell by more than 1% against the dollar in a single session – a significant drop for a usually stable currency. What caused such turmoil? The Labour government's reversal on social benefits reform, which will create a £5 billion hole in the budget, is to blame.

How to emerge successfully? The government will have to increase taxes in the fall or reduce spending at the risk of alienating backbenchers who are gaining influence and could provoke early elections to express their dissatisfaction. While waiting for a definitive decision, which could take several weeks, turmoil may continue. Added to this are concerns about the UK economy, particularly the labor market, which is showing rapid signs of slowing down. This could force the Bank of England (BoE) to lower its key rate faster and more significantly than expected, potentially as early as August. This is the bet made by the options market. It's credible, in our opinion.

What lesson to learn from all this? When you are heavily indebted, as is the case with the UK, the slightest problem can lead to instability of your currency. Something to ponder.

In the eurozone, some members of the European Central Bank's (ECB) Governing Council have cast doubt on an upcoming rate cut. Isabel Schnabel, a German board member, is reluctant to the prospect of another cut. She is considered influential, but in recent months, her opinion appears to be in the minority within the institution. With inflation expected to reach 1.6% next year according to ECB experts, and the risk that it may be even lower due to the strength of the euro, it's hard to see what would prevent a 25 basis point cut as early as this week. This is, moreover, the central scenario of the foreign exchange market.

Across the Atlantic, the question of Jerome Powell's retention as head of the US Federal Reserve (Fed) continues. Several associates of President Donald Trump have suggested that a resignation is possible. The power struggle between the White House and the Fed concerns the scale of rate cuts to be made. Barring surprises, the central bank is expected to keep its key rate unchanged in July and start a rate cut only in September. Trump wants to act now and advocates for a 100 basis point cut in one go – a highly unlikely scenario, in any case. Let's be clear, the Trump administration has no legal lever to remove Powell. However, Congress can do it or, at least, significantly influence US monetary policy. It can, for example, vote on a resolution calling for a cut in key rates. The Fed might be forced to comply. It is little known, the real boss of Powell is not Trump but the US Congress.

Technical point

In the forex market, profit-taking continues on EUR/USD. This is not unusual in a market that is rather very calm. It does not question the underlying upward trend, for now. A similar movement is also observed against the Canadian dollar, for instance.

The only notable exception is against the Japanese yen. The yen is undervalued by at least 20% compared to the euro. However, we do not foresee a reversal of the upward trend of the EUR/JPY pair over a six-month horizon. The Bank of Japan seems reluctant to raise its policy rate, perhaps because it wants a weaker yen to offset US tariffs targeting the Japanese automotive sector. We do not rule out a rate hike in the fourth quarter. But this is very uncertain and will depend on the evolution of national inflation and the trade war. On several occasions in recent months, the market has predicted a rate hike that ultimately did not occur. Hence our caution. Since the beginning of the year, the EUR/JPY pair is up by +5.8% at 172 yen per euro. Our year-end target is 176 yen – slightly above the highest point in the last decade.

Announcements to follow

As we mentioned earlier, barring any last-minute surprises, the ECB's rate cut is expected and already priced into the euro. However, it will be interesting to see if the institution opens the door to a future cut in the fall. Unusually, it might let doubt linger.

Powell's intervention should not cause major movements on the dollar pairs, in our view. He should confirm what he has repeated on several occasions in recent weeks. A rate cut is excluded during the July FOMC meeting. It is conceivable in September if inflation continues to decline – this is our scenario.

Below you will find the publications and events that should have a major impact on currency price developments.

The information presented in this publication is provided to you purely for informational purposes and does not constitute investment advice, an offer to sell, nor a solicitation to buy, and should not be used as a basis for or considered as an inducement to engage in any investment.