The Fed’s pause, the ECB’s problem

USD: Fed pause, data test ahead

The Fed’s decision to leave rates unchanged at 3.75%-4.00% was largely in line with expectations, but the dollar’s muted reaction highlights a market unwilling to reward hawkish rhetoric without a meaningful shift in the policy outlook. While the two dissenting votes underscore ongoing debate within the FOMC, Chair Warsh stopped short of signalling a December move, instead reiterating that incoming data will determine the next step. As a result, the USD gave back its initial gains.

The dollar’s softness was mirrored in rates markets. Front-end yields declined as investors focused on the pause rather than the possibility of further tightening, while longer-dated yields remained anchored near 5% amid persistent inflation concerns and ongoing AI-related investment demand. The resulting bull steepening in the Treasury curve pushed the 2s10s spread above 30bp and further eroded the USD’s yield support.

Warsh also pushed back against the idea that the economy is overheating. However, nominal GDP growth remains inconsistent with a return to the Fed’s 2% inflation target, having recently reached its strongest pace outside the post-pandemic rebound. Today’s GDP release will therefore be closely watched for signs of moderation.

Nearer term, however, the PCE inflation data may prove more important for markets. Consensus expects headline and core PCE to rise to 3.6% and 3.1% respectively. A softer-than-expected print, particularly alongside slower nominal GDP growth, would help validate the Fed’s decision to pause and reinforce expectations that September’s hike marked the end of the cycle. That would likely weigh further on front-end yields and the dollar.

Conversely, stronger inflation data would force markets to reassess the extent of further tightening required. Fed funds futures currently price around 65bp of additional tightening over the next year, and an upside surprise in core PCE could push expectations closer to three further hikes. In that scenario, front-end Treasury yields and the USD would likely rebound, particularly given the 25bp decline in two-year yields since last month’s peak.

EUR: ECB faces a difficult balancing act today

Today’s European Central Bank (ECB) meeting comes at an awkward time for the euro. Despite an 18% rally in Brent this month, markets have barely added to ECB tightening expectations, with swaps still pricing ~75bps of hikes through end-2027.

France is a key reason. Wider OAT spreads and ongoing fiscal concerns have raised the bar for further tightening, while softer eurozone data and falling economic surprise indices reinforce the case for caution. Lagarde’s recent comments also suggest little urgency to respond to energy-driven inflation given the absence of meaningful second-round effects.

We think the ECB therefore faces an uncomfortable trade-off. A more dovish tone could help ease pressure on French and broader euro-area sovereign debt markets, but risks widening policy divergence with the Fed and weighing further on EUR/USD. Equally, maintaining a tightening bias risks keeping borrowing costs elevated and prolonging strains in French fixed income markets, which could also prove euro negative.

In that sense, the ECB’s policy dilemma increasingly looks like a lose-lose proposition for the single currency. As flagged yesterday, though, the confluence of support around 1.11 continues to hold. For now, that leaves EUR/USD at a critical juncture, with today’s ECB communication likely to determine whether the next move is a deeper retracement towards the low-1.10s or another temporary reprieve for the euro.

GBP: No surprises, no problem

That was the sort of Budget we had expected: no major policy surprises and, quite frankly, a bit boring.

But that’s exactly what markets needed, something pragmatic, not overly risky, and a continuation of the party’s fiscal consolidation commitments.

Healey announced a range of cost-of-living measures, particularly aimed at addressing rising energy bills, alongside increases to the bank surcharge and gambling taxes, as well as modest capital spending. Importantly, this spending is exempt from the fiscal rule requiring the current budget to be in surplus within five years.

Overall, the independent Office for Budget Responsibility (OBR) forecasts the budget deficit to fall to 3.4% of GDP in 2027, down from 4.2% this year. Even after the Iran war, this year’s deficit is still an improvement on last year’s 4.4%.

Gilts rallied, while the pound was moderately softer. Overall, the response across UK assets was relatively muted.

What may have been the more notable development was fiscal headroom, which fell to £15 billion from £23.6 billion in March. Headroom had been expected to decline to £15.2 billion, according to government bond dealers surveyed by Bloomberg, although many forecasts had pointed to a figure closer to £10 billion. As such, the outcome was not particularly concerning.

Then came the OBR forecasts. UK GDP growth for 2026 was revised up to 1.2% from 1.1%, but the 2027 forecast was lowered to 1.0% from 1.6%.

While markets seemed largely unfazed by the downward revision for now, weaker growth could become more of an obstacle over time, especially as many of the fiscal measures announced are relatively small in scale and therefore harder to forecast accurately. Ultimately, stronger tax revenues may be the only way out of this fiscal limbo.

For now, sterling can take a breather, although it never seemed particularly concerned heading into the Budget. Next week’s BoE policy decision is now in focus, with a rate hike priced in with near certainty. The pound is likely to trade relatively quietly ahead of the event.

Market snapshot

Table: Currency trends, trading ranges & technical indicators

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Calendar: October 26-30

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*The FX rates published are provided by Convera’s Market Insights team for research purposes only. The rates have a unique source and may not align to any live exchange rates quoted on other sites. They are not an indication of actual buy/sell rates, or a financial offer.