Markets steady ahead of final push on the debt deal

After a long weekend in many parts of the world, FX markets are returning to mull progress on a US debt ceiling deal. This now must pass the committee stage in the House and will probably go to a House vote today/tomorrow. Progress on the deal will allow investors to focus on sticky US inflation – likely seeing the dollar hold onto recent gains.

USD: Progress on debt deal allows markets to focus on another Fed hike

Following an extended weekend across various regions, the foreign exchange (FX) markets are witnessing some progress regarding the US debt ceiling. President Joe Biden and House Speaker Kevin McCarthy have successfully reached a two-year agreement. Today/tomorrow, the House Rules Committee will assess the deal, and if it receives approval (most likely), it will likely proceed to a vote in the House tomorrow.

Both Democratic and Republican leaders are confident about securing enough votes to pass the deal through Congress. However, there may be a few politicians who are hesitant and prefer to draw attention to themselves during such times. Although progress on the debt deal has caused some declines in yields for US Treasury Bills maturing in June, its impact on FX markets has been minimal. As I mentioned last week, FX markets were already trading in a relaxed manner, assuming that a deal would be reached. Assuming no obstacles arise during the deal's passage, FX markets can shift their focus back to the urgent matter of persistent inflation and the measures that central bankers intend to take to address it.

The recent US data released on Friday has strongly supported the case for an additional 25 basis points (bps) Federal Reserve (Fed) hike, which is now fully anticipated by the time of the meeting on July 26. Money markets currently price a 63% likelihood of that hike occurring earlier at the meeting on June 14, a gathering that will likely require the Fed to revise its inflation forecasts upwards. Consequently, the prevailing consensus suggests that the dollar can maintain its recent gains, at least until the June meeting, unless US price and activity data exhibit a significant and sudden decline. Regarding this, the upcoming week includes the release of US JOLTS job opening data on Thursday, ADP data on Thursday morning, and the May Non-Farm Payrolls (NFP) report on Friday. Unless these releases indicate a significant downside miss, it appears that the market will support another 25bps hike from the Fed, continued inversion in the US yield curve, and a strong or even stronger dollar. The US Dollar Index (DXY) appears comfortable above the 104.00 level and has the potential to extend its recent gains to 104.65 or even 105.30 throughout this week.

EUR: Can China come to the Euro's rescue?

The EUR/USD pair has quietly slipped below the support level at 1.0700/1.0720 and appears to be gradually heading towards the March lows at 1.0515/0530. As I mentioned previously, I believe that EUR/USD is relatively undervalued, considering the significant reversal in energy prices observed over the past year.

Eventually, the 1.05/1.07 range may be regarded as a summer base. A potential factor that could support this notion is a recovery in China. The China Beige Book has indicated some improvement in the country's manufacturing sector in May, and official Chinese PMI figures for May are scheduled for release later this week. If there is a rebound, helping to reverse the recent increase in USD/CNH, it could provide support to the Euro.

Market consensus expects further deterioration, which could keep EUR/USD biased towards the downside. Additionally, we had the speech from several ECB representatives yesterday, and it was a bit of a hawkish rhetoric, particularly in anticipation of the Eurozone CPI data for May, which will be released on Thursday. Consensus expects core Eurozone CPI to slightly decline to 5.5% year-on-year in May. However, another positive surprise here, fuelling the narrative of persistent inflation, warns that investors may start pricing in a 4.00% ECB deposit rate.

GBP: Hard to fight the aggressive BoE pricing

Money markets currently indicate a 100-basis point tightening by the Bank of England (BoE) by November, which would result in a Bank Rate of 5.50%. I hold the view that such a significant level of tightening is highly improbable, and it is possible that the typically reserved BoE may attempt to verbally counteract these expectations.

Nevertheless, the UK's economic data is playing a crucial role in shaping market sentiment, and it will likely be the upcoming jobs/wages data on June 13th or the May CPI data on June 21st that will have the most significant impact on whether the market curbs its aggressive tightening expectations.

Until then, EUR/GBP is likely to encounter support around 0.8650, with the next target being 0.8600/8610. On the other hand, GBP/USD  may exhibit greater resistance to the strength of the dollar. There is a possibility that support in the 1.2275/2300 range could hold temporarily.