Sterling weakened on Thursday, even as the US dollar remained under pressure across the broader foreign exchange market. Softer US inflation figures strengthened expectations that the Federal Reserve may be approaching the end of its monetary tightening cycle.
However, the pound’s latest decline appears to be a temporary pause within its recent short-covering rally rather than the beginning of a deeper reversal.
Pound Falls While Euro Holds Steady
At 08:03 ET, or 12:03 GMT, GBP/USD traded at 1.3509, representing a decline of 0.21% during the session. Meanwhile, EUR/USD remained broadly unchanged at 1.1470.
Francesco Pesole, foreign exchange strategist at ING, said the US dollar continued to face selling pressure. He also noted that currency-market volatility had resumed its downward trend following a brief rebound earlier in the week.
Softer US Inflation Data Weighs on Dollar
The latest US inflation figures reinforced expectations that the Federal Reserve may soon pause its interest-rate increases.
US producer prices came in below market forecasts. Headline Producer Price Index inflation declined by 0.3% month-on-month, while the core reading increased by only 0.2%.
According to Pesole, Brent crude trading near $85 per barrel had not produced a significant rise in inflation expectations. As a result, short-term US yields and the dollar continued to feel downward pressure following the softer June Consumer Price Index report.
Federal Reserve Officials Urge Caution
Federal Reserve Chair Kevin Warsh and Governor Chris Waller warned investors against drawing major conclusions from a single inflation report.
Waller argued that the disinflationary trend must continue for several months before the Federal Reserve can confidently end its rate-hiking cycle. Rising oil prices could make that decision more difficult, particularly if renewed energy inflation begins affecting broader consumer prices.
Markets currently expect the Federal Reserve to deliver one additional interest-rate increase this year.
Investors will also monitor comments from policymakers Lorie Logan and Jeffrey Schmid later on Thursday. In addition, June US retail sales are due for release, with economists expecting monthly growth of 0.2%.
Sterling Rally Driven by Position Adjustments
The pound’s recent recovery does not appear to be based primarily on an improvement in the UK economy or a major change in monetary-policy expectations.
ING strategist Chris Turner said sterling’s advance was mainly caused by traders adjusting their positions rather than conducting a significant reassessment of the UK’s economic outlook.
Speculative investors had recently built their largest net-short sterling position since 2017. This created the conditions for a short-covering rally as traders closed bearish positions and repurchased the pound.
Turner believes this process could continue ahead of next week’s UK inflation and employment reports.
UK Political Developments Support Sterling
EUR/GBP moved below the important 0.8500 level following reports that Shabana Mahmood could be selected as chancellor by incoming Labour leader Andy Burnham.
Mahmood is viewed as being positioned on the more moderate side of the party. Markets may therefore consider her less politically divisive and potentially less supportive of aggressive fiscal expansion than Ed Miliband.
UK government bonds also outperformed their German equivalents by approximately five basis points on Wednesday, providing additional support for sterling.
Euro Upside Could Remain Limited
ING sees limited potential for a sustained euro rally unless there are clear signs that tensions in the Middle East are easing.
Higher European natural gas prices could also restrict the euro’s performance. Gas prices have a greater effect on the eurozone’s terms of trade than crude oil because the region remains heavily dependent on imported energy.
Therefore, any independent bullish narrative for the euro may remain difficult to sustain.
Key EUR/USD and GBP/USD Levels
ING expects selling pressure to emerge if EUR/USD approaches 1.1500. The bank therefore favours a period of range-bound trading rather than a decisive breakout above that level.
The European Central Bank has also entered its pre-meeting quiet period, limiting the amount of new guidance available from policymakers.
For sterling, ING believes GBP/USD could test the 1.3600 to 1.3650 area if short-covering continues.
Meanwhile, EUR/GBP could fall towards 0.8400 if the pair remains below 0.8470. However, Turner expects EUR/GBP to eventually recover towards the 0.8600 to 0.8610 region once position-adjustment flows weaken.
At that stage, investors are likely to refocus on UK economic conditions and the Bank of England’s monetary-policy outlook. According to Turner, that shift may take place later in the month.
