Conflicting Forces, but Debt Ceiling Dominates.

There is still a rather convincing bearish story on the dollar as US short-term rates remained under pressure on the back of Fed rate cut speculation. But FX is looking at the debt ceiling concerns, and the impact on sentiment, with more urgency and interest. Negotiations restart today, but more upside risks for the dollar look to be on the cards.

USD: Debt ceiling jitters raise upside potential in near term – Bullish

As a new week begins, the dollar maintains a relatively stable position despite contrasting factors that have led to significant fluctuations throughout the eventful month of May.

Two primary opposing forces are currently at play: declining short-term US rates, anticipated due to potential Federal Reserve rate cuts, and the ongoing deadlock over the debt-ceiling in Washington.

Regarding data, although strong job figures were reported for April, there were indications of a potential slowdown in service inflation, below-consensus PPI, and higher-than-expected jobless claims, suggesting a rise in layoffs. This week, the focus will be on retail sales and industrial production. It is anticipated that robust auto sales in April will boost retail sales, while manufacturing surveys continue to indicate a decline in production, partly due to lower energy prices affecting oil and gas extraction. Additionally, the upcoming jobless claims report will receive specific attention.

The pricing of the December contract in the Fed funds futures market remains volatile, fluctuating between expectations of 65bp and 75bp in rate cuts. Among all the data to be released this week, jobless claims have the potential to have the most significant impact on rate expectations. However, the remarks made by Federal Reserve officials will also be closely monitored. The week's Fed speak calendar will culminate with a speech by Chair Jay Powell on Friday.

This week, there may be some resistance to expectations of rate cuts, which could offer temporary support to the dollar. However, the sustainability of a positive outlook for the dollar does not seem reliant on the rate side. Two-year dollar swap rates remain near their lows, only slightly above the significant psychological mark of 4.00%, and the market has demonstrated a tendency to anticipate rate cuts aggressively. At this stage, what is truly bolstering the dollar is the ongoing impasse over the debt-ceiling in Washington. I believe that unless there is genuinely encouraging progress in negotiations between President Biden and congressional leaders, investor concerns will persist. Unless positive news emerges on this front, I believe the dollar is likely to continue benefiting from safe haven flows as overall risk sentiment remains subdued. The DXY rebound could potentially extend to the 103.50/104.00 range in the upcoming days.

EUR: Looking across the Atlantic – Bearish

The dollar will likely continue to be the primary driver of movements in EUR/USD. The FX markets are primarily focused on the US, particularly the impasse over the debt limit and speculation surrounding the magnitude of future Fed easing. On the other hand, the Eurozone calendar remains relatively uneventful this week, apart from the ZEW surveys and preliminary 1Q GDP figures today.

While it will be interesting to hear from European Central Bank (ECB) speakers, their impact on the Euro has been limited in recent times. Market expectations for the July meeting, following the well-communicated June hike, have remained largely unchanged, with approximately 15bp of additional tightening anticipated. Today, we will hear from Joachim Nagel, an arch-hawk, and later in the week, President Christine Lagarde and other Governing Council members will share their perspectives.

My outlook for EUR/USD this week aligns with my view on the USD, considering the absence of significant domestic drivers in the Eurozone. The pair faces downside risks due to the US debt ceiling impasse, and if the risk environment deteriorates further, we may witness a break below the key level of 1.0800 (also the 100-day moving average), followed by a decline to the 1.0700/1.0750 range. However, I do not anticipate prolonged weakness in EUR/USD beyond the near term.

GBP: Wage data is key for sterling

The upcoming policy move by the Bank of England (BoE) in June will heavily hinge on two key data releases: wages and inflation. The wage data will be unveiled on Tuesday, and it's worth noting that wage figures have exhibited significant volatility recently. As a result, the outcomes for the sterling are expected to be extremely sensitive to these releases.

Few economists anticipate a slowdown in wage growth following last month's surge, which could potentially sway the Monetary Policy Committee (MPC) towards a decision to maintain the current policy stance at the June meeting. Market expectations currently factor in a 20-basis point tightening, but there are notable downside risks for the sterling. I predict that this will be reflected in a strengthening of the Euro against the pound, with EUR/GBP likely to rebound above 0.8800 by the end of this month.

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