Market pricing proved wrong
For a few weeks now we’ve discussed the gap between inflation driven by economic activity and market expectations for a Bank of England policy tightening. Well, last week, we finally heard from the Monetary Policy Committee and our reading was on the money. While it’s appropriate that the markets begin driving interest rates higher in anticipation of hikes, the issue is how soon they expect them to rise.
Inflation has largely been driven by supply disruptions and an explosion in energy prices, both of which act to dampen the aggregate demand which monetary policy action acts upon. Unfortunately, the market is too accustomed to forecasting policy on total ‘headline’ inflation and less on the core element that accounts for price rises occurring from underlying economic activity. Does that mean the market got it completely wrong, as indicated by the sell-off of the Pound following the Bank of Englands policy statement? Yes and no.
The complexity comes when we consider the fleeting nature of external inflation impacts. To really understand energy price contributions to inflation, we must look at the total price level and the demand dynamic.
- Brent Crude is already trading at post-2014 highs and has risen 60% year-to-date. This argues that a particularly strong stimulus is required to shift it up towards 2014 levels, and the impact of Crude in the inflation reading is likely to be limited going forward.
- Of course, a larger problem in the EU and UK is reliance on natural gas for heating during the winter. The 300% price rise in natural gas—arguably somewhat attributable to a Russian powerplay—is having a large downward impact on disposable income, and therefore, demand. This is likely to persist for the next three to four months until spring. Then, we can expect supply/demand dynamics to change and the pricing pressure to recede. We might also expect the stifling effect on UK economic activity to reverse, which is the key takeaway.
Bottom line: In our view, successfully judging the timing of this reversal is the key factor in anticipating central bank action. By itself, the underlying economy is simply not running hot enough, and we aren’t free enough of other risks to the growth outlook—UK article 16 activation being one big one—to force the MPC down a path of policy tightening. Since no progress is being made with OPEC+, which has an interest in high oil prices, and Russia is thought to be using the gas supply as leverage for the accelerated opening of the Nord Stream 2 pipeline, it seems unlikely that we can expect this until spring of 2022. This makes the BoE meeting on the 3rd of February the most likely for interest rate hikes as we should then have a clear picture of the development of economic activity and the effects of elevated energy prices will be waning. So, the market got it wrong in terms of timing, but market opinion is unlikely to sway too much. If gas prices continue to impact inflation into the end of the year, and that is probable, the bias towards higher rates is also likely to remain skewed over the same period.
The week ahead
Sterling slid to multi-week lows last week as markets were taken by surprise at the scaling back of expectations for a BoE interest rate hike. Cable closed around 1.5% lower on the week in its worst run against the US Dollar since August. Markets had priced in a rate hike to 0.25% from the historic low of 0.10%, but the BoE failed to follow through on expectations. Brexit tensions surrounding the Northern Ireland protocol have also hampered Sterling, with the UK reportedly planning to trigger the Article 16 safeguard in an attempt to re-work the current legislation around trade. The UK 10-Year Gilt Yield was trading near six-week lows this morning, while GBP/USD is finding resistance at the $1.35 level.
- Bank of England Governor Andrew Bailey is due to speak at 5:00PM today, and also at 4:00PM on Tuesday at an open forum and central bank conference.
- Monetary Policy Committee members Silvana Tenreyro and Jonathan Haskel will speak on Wednesday at 1:30PM and Friday at 2:00PM, respectively.
- The UK’s preliminary Gross Domestic Product q/q is due to be released on Thursday and is forecast to read 1.5% in Q3 versus 5.5% in Q2.
- UK Industrial Production m/m looks set to fall to 0.2% in September from 0.8% in August.
EUR/USD fell around 0.40% last week as the common currency came under pressure following the Federal Reserve announcing its official commencement to tapering. European Central Bank President Christine Lagarde made it clear on Wednesday that the ECB would be unlikely to raise interest rates next year with long-term inflation not expected to be high enough to warrant a hike. Markets have shifted their expectations but have still deviated from the proposed forward guidance and now expect a rate hike in December 2022 rather than October next year. It’s a fairly quiet week for EU data with fresh sentiment surveys due and updated economic forecasts to bookend the week.
- German and Eurozone Economic Sentiment readings are due on Tuesday, with both looking likely to fall to 20.3 and 20.6 respectively from 22.3 and 21.0 last month.
- European Central Bank President Christine Lagarde will be speaking at the ECB Forum on banking supervision this Tuesday at 1:00PM.
- German Bundesbank President Jens Weidmann speaks this Wednesday at 9:00AM.
- The EU will publish the latest set of economic projections for the bloc this Thursday.
The US Dollar Index managed to close 0.5% higher last week, with the latest Federal Reserve meeting concluding with the start of tapering and the release of a positive Non-Farm Payrolls report. The S&P 500 continued to climb last week, extending its rally to a seventh day on Friday, while the Nasdaq 100 managed the tenth day in the green. After the most recent Federal Reserve meeting, attention has shifted towards Jerome Powell and whether the Biden administration will re-appoint the incumbent. Powell has three months left in his current term, and the window is starting to narrow for Biden to make a decision or risk destabilising financial markets in an already precarious economic environment.
- Federal Reserve Chairman Jerome Powell will be speaking today at 3:30PM and again on Tuesday at 2:00PM, along with a number of Federal Open Market Committee members throughout the week.
- US Producer Price Index and Core PPI m/m will be released on Tuesday, with expectations of 0.6% and 0.5% respectively for October compared with 0.5% and 0.2% readings in September.
- US Consumer Price Index and Core CPI m/m are also due out this Wednesday, with forecasts indicating 0.5% and 0.4% readings in October versus 0.4% and 0.2% in September.
- The preliminary University of Michigan Consumer Sentiment reading will be released on Friday and is expected to print at 72.5, higher than the reading of 71.7 in October.
- The US Treasury Currency Report will also be released this Friday.
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