The German ZEW index dropped sharply, signalling a challenging Q3 outlook. Despite weak data, sticky inflation prevents a dovish shift in ECB policy, supporting the EUR. Geopolitical risks, particularly the Russia-Ukraine conflict, may drive inflation higher. In contrast, the Pound stabilized as UK data showed economic resilience, with strong Q2 GDP, retail sales, and labour market results. However, the July CPI report revealed slowing inflation, easing BoE rate hike pressure. Markets now see a 38% chance of a September rate cut, while unwinding long GBP positions adds near-term risk.

EUR: Weak bullish still a bullish

In the past trading week, as risk sentiment continued to stabilize, the EUR experienced a moderate recovery, with EUR/USD even breaking above the 1.10 level, bolstered by weak U.S. data. Looking ahead, the EUR could maintain its strength if risk sentiment remains stable, particularly if U.S. exceptionalism continues to wane. However, recent data from the eurozone has been less encouraging than expected. The German ZEW Current Conditions index fell to -77.2 from -68.9, while Economic Sentiment plunged to 19.2 from 48.2, signalling a deteriorating outlook and a setback in Germany’s modest economic recovery earlier this year. Additionally, the preliminary Q2 GDP showed a modest expansion of +0.3% q/q, suggesting that the outlook for Q3 has become more challenging, raising concerns about potential economic contraction or stagnation.

Despite growth concerns, stickier-than-expected inflation is preventing a significant dovish repricing in the EUR curve. This is a key factor for the EUR in the near term, along with improving risk sentiment following the recent selloff. Geopolitical uncertainty, particularly regarding the Russia-Ukraine conflict, adds another layer of complexity. Ukraine’s largest incursion into Russian territory since the war began in 2022 has displaced over 100,000 people and driven European gas prices to their highest level this year. This increases the risk of supply chain disruptions, which could heighten inflationary pressures and support the EUR.

Looking ahead, the market will focus on the July CPI, which is expected to show a slight uptick due to recent unfavourable developments in the eurozone. During its July meeting, the ECB signalled that due to high domestic price pressures, elevated services inflation, and the likelihood of headline inflation staying above target well into next year, inflation is anticipated to fluctuate around current levels for the remainder of the year, partly due to base energy effects. As a result, ‘bumpy’ data is unlikely to cause significant movements in the EUR, as markets have largely priced in this scenario. In summary, while the ZEW survey for Germany indicates soft eurozone activity, persistent inflation does not allow markets to price in more than a 75bp cut by the ECB by year-end.

GBP: In the junction

During the past trading week, the Pound stabilized for several reasons. First, UK economic data was generally encouraging, with a mixed picture from the labour report and July CPI, while Q2 GDP and July retail sales continued to show the UK economy's resilience. However, these data points make it challenging for the BoE to justify back-to-back rate cuts for the remainder of 2024. Additionally, favourable US data, including July CPI, retail sales, and weekly initial jobless claims, demonstrated that the US economy remains far from a recession. This positive risk sentiment has also supported the Pound.

Notably, the UK labour report showed payroll employment increasing by an estimated 24k in July and by 252k over the past year, with the unemployment rate falling by 0.1% to 4.2% in Q2 as the number of unemployed dropped by 51k. Despite concerns, the labour market remains relatively strong, with encouraging signs that wage growth is slowing. The July CPI report revealed a cooling in all measures, with services inflation notably slowing to 5.2% y/y in July, below the BoE's 5.6% forecast. This CPI data is favourable for the BoE, and currently, markets are pricing in a 38% probability of a rate cut in the September meeting.

On the other hand, Q2 GDP and July retail sales data further underscore the UK's economic resilience, with Q2 GDP at 0.6% q/q and 0.9% y/y. Meanwhile, retail sales rebounded to +0.5% m/m from -1.2%, and 1.4% y/y from -0.3%. These data points suggest that the BoE may delay rate cuts. However, recent positioning data from leveraged funds indicate that long GBP positions are unwinding, leaving the currency vulnerable to near-term weakness.

Looking ahead, the market focus will be on the UK flash PMI, with expectations for the services print to hold steady at 52.5, manufacturing to ease slightly to 52.0 from 52.1, and the composite PMI to remain at 52.8. However, from a policy perspective, this release is unlikely to significantly impact BoE pricing, as the MPC is primarily focused on services inflation and real wage growth. In summary, while the UK economy continues to demonstrate resilience, the encouraging July CPI report and the unwinding of long GBP positions suggest potential near-term weakness for the Pound.

EUR/GBP 4H Chart

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