HomeContributorsFundamental AnalysisAs Dollar Fights Back, Can Flash PMIs Revive Euro and Pound Rally?

As Dollar Fights Back, Can Flash PMIs Revive Euro and Pound Rally?

The flash PMI readings for July are due on Monday for the major economies. The highlights as usual will be for the euro area (08:00 GMT), the United Kingdom (08:30 GMT) and the United States (13:45 GMT). Economic growth has been losing steam in most parts of the world amid surging interest rates, but the pace of disinflation has been somewhat less synchronized. This has put the spotlight on monetary policy divergence as far as the FX market is concerned. Thus, how the euro, pound and US dollar react will vary on whether the data will magnify or lessen this divergence. 

Teetering on the brink of recession

European economies have slowed sharply this year, as higher prices and borrowing costs have squeezed households’ purchasing power, while a weakening recovery in China has depressed demand for manufactured goods, particularly for German exporters. The services sector remains a bright spot, but even there, momentum is waning.

The good news is that inflation is also on the way down, with the Eurozone headline figure falling to 5.5% in June. This has raised hopes that the ECB doesn’t have that much to go with its rate hiking cycle and if there is a recession, it will be a mild one.

The composite PMI fell to 49.9 in June, indicating a slight contraction for the euro area. The UK’s composite PMI stood at a healthier 52.8 in June and it was even higher in the US at 53.2.

However, despite the disparity in the PMIs, actual GDP growth in the UK has been stagnating and not that much higher than the Eurozone’s in recent quarters. It’s only the US economy that’s growing at a respectable pace.

‘Higher for longer’ clouding the outlook

Nevertheless, the risk of a recession continues to hang over all the big economies as central banks are not quite fully done with rate increases, and perhaps more importantly, rates are set to stay elevated for some time. In such a macroeconomic backdrop, investors have to weigh economic prospects against the spreads in real interest rates, and this is where it gets complicated for the dollar outlook.

The Eurozone economy seems the most vulnerable to rising interest rates but if inflation continues to decline rapidly, then the ECB could potentially pause after just additional hike. The British economy has so far defied dire predictions but unless inflation drops more substantially in the coming months, there is a strong possibility that the Bank of England will have to hike rates to at least 6.0%, making it the highest in the developed world and exacerbating the economic pain.

America, meanwhile, is enjoying the best of both worlds – it currently has the lowest inflation and it is the furthest away from a broad-based downturn.

Upbeat PMIs may be a mixed blessing

So where does this leave the euro and pound against the mighty greenback? If the flash PMIs point to a slight pickup in European and UK business activity in the first half of July, this would probably be a mixed blessing for the two currencies.

The more resilient the economy, the more likely that policymakers will feel confident to keep playing it safe and raise rates until CPI is on a sure path to 2%. But with both economies so fragile, rates are already very close to the tipping point of a recession.

In the US, there is less of a question about how much higher rates will go and it’s more about how many times the Fed will cut rates in 2024. Investors seem certain that once core inflation dips below the 2% target, rate cuts will follow. But in reality, when the labour market is so tight at this late stage of the business cycle, that is a testament to the underlying dynamism and the Fed will not want to risk allowing the economy to overheat again by cutting rates too early.

Can the dollar extend its recovery?

However, it may be a while yet before traders are forced to rethink their rate cut predictions and in the immediate term, the dollar could face renewed selling pressure if Monday’s PMIs lift some of the gloom for the euro and pound and at the same time, point to weaker growth in the US.

There are considerable downside risks too for the euro and pound as the past week has shown. With the recent rally potentially built on the misguided expectations that the ECB and BoE will remain hawkish well after the Fed has pivoted, their pullback could accelerate if European and UK PMIs continue to edge lower.

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