Quite a shift
Early this month, we compared US and UK interest rate expectations to draw the conclusion that expectations of a UK rate hike were a bit overcooked. Well, since then, things have only gotten more extreme. Last week, the market predicted almost four quarter-percent rate hikes by May next year, which is triple the amount expected at the beginning of the month.
There are a few good reasons we believe this to be an extreme position, including the composition of inflation and fiscal policy. On the first score, inflation isn’t a concept so simple that when we spot it, we raise interest rates. The contributors to inflation matter because some inflation is a sign of excess demand in the economy, and another type is a sign of external pressures or supply constraints weighing on economic growth. Invariably an economy experiences both, but alleviation requires policymakers to measure, weigh, and predict each source of inflation to understand how the composition will impact growth.
In the UK, underlying demand is rising. This supports a view for interest rate increases in the near term, although external pressures—energy prices since we’re an energy importer—and supply chain disruptions—Covid and Brexit are both contributing some chaos—are dampening economic activity. So on net, a modest increase might be expected. However, what we see is a full percent priced in for May of next year. That’s quite a shift for an economy that’s just at the start of recovery from Covid.
Bottom line: It may seem that the proceeding analysis didn’t consider any changes to fiscal policy spending, but that’s not what's happening. This morning, Chancellor of the Exchequer Rishi Sunak doubled down on fiscal spending cuts in response to rising costs. There’s no doubt that he understands the distinction we’ve drawn above, but he’s chosen to represent inflation as primarily a sign of economic growth. Removing government spending will further dampen economic activity and argues against the immediate need for monetary policy tightening. The market has pulled back a bit on this news, but we’re still in a zone that augurs a greater deal of optimism for the UK economy than is present in current economic data.
The week ahead
Sterling has moved lower this morning in what seems to be a continuation of last week’s trend, while expectations around a Bank of England interest rate hike continue to build. New BoE Chief Economist Huw Pill has been vocal on the potential for higher inflation, indicating that a 5.00% reading is not out of reach in the coming months. This positions the central bank for a 0.15% rate hike in the November meeting, but probabilities have fallen to around 60.00% over the weekend after Pill warned that markets have become ‘too excited’ around rates. Some positivity around the Northern Ireland protocol is providing support to the Pound, with UK officials engaging in ‘constructive’ talks with the EU. Elsewhere, Covid-19 booster shots look likely to be brought forward as the government aims to avoid re-introducing some Coronavirus restrictions; new cases were topping 50,000 a day at the end of last week.
- Monetary Policy Committee member Silvana Tenreyro is expected to speak today at 2PM at an event hosted by the Center for Economic and Policy Research.
- On Tuesday, the Confederation of British Industry Realised Sales figure is due in at 14, up from 11 in September.
- Friday’s M4 Money Supply m/m is expected to creep higher to 0.6% in September versus 0.5% in August.
- Friday is also set to see Mortgage approvals in the UK in September fall slightly to 72K following the 74K August figure.
In an economic environment saturated by talk of tapering and interest rate hikes, the European Central Bank has kept the consistent attitude that inflation rises are bumps in the road with moderation expected next year. Markets will be waiting for the latest monetary policy statement on Thursday to see if there’s any shift from this dovish policy stance. As growth in the price of services and wages lags behind, a sudden hawkish tilt from the central bank could be a cause for concern. German IFO data released this morning has highlighted the continued deterioration in business sentiment as supply chain issues continue to squeeze production. EUR/USD has lowered in early trading to the $1.1620 level while the Euro Stoxx 600 trades range-bound at the start of the European session.
- The German Gfk Consumer Climate due out on Wednesday is expected to dip lower for November as confidence takes a hit. A reading of -0.4 is predicted following 0.3 last month.
- The European Central Bank’s latest Monetary Policy Statement will be released this Thursday alongside any interest rate decision. Consensus still indicates no movement from the 0.0% baseline rate.
- German Preliminary Gross Domestic Product q/q for Q3 is forecast to come in at 2.2% in a positive trend higher for the German economy, which expanded 1.6% in Q2.
- The Eurozone Consumer Price Index y/y flash estimate is to be released on Friday, with markets expecting yet another shift higher to 3.7% in October versus 3.4% September.
The US Dollar Index has ticked higher this morning, gaining 0.14%, buoyed by the move higher in the US 10-year Bond Yield which reached 1.66% in early trade. On Friday, Federal Reserve Chairman Jerome Powell announced the US is ready to start tapering asset purchases but emphasised it’s not yet ready to begin raising interest rates. The markets have effectively priced in the first rate hike to occur in July 2022, with around a 50.00% chance of a hike as early as May 2022. Core Personal Consumption Expenditures data, the Federal Reserve’s main barometer of inflation, will be closely watched during its release on Friday. A number of companies have sounded the alarm on inflation with supply chain pressures creating rising costs for consumers; Proctor & Gamble announced price rises for 9 of its 10 product categories last week. Tech giants such as Amazon, Apple, and Facebook will be the ones to watch with their latest round of earnings due this week.
- The Conference Board Consumer Confidence is predicted to fall this month to 108.4 after reading 109.3 in September.
- Durable Goods Orders m/m are expected to fall -1.1% in September versus 1.8% in August, while Core Orders are forecast at 0.4% after coming in at 0.3% previously.
- Advance Gross Domestic Product q/q for Q3 is predicted to be weaker at 2.6% compared to the 6.7% revised reading in Q2.
- The latest US Core Personal Consumption Expenditures Price Index m/m reading is due on Friday with market expectations of 0.2% in September versus 0.3% in August. The US Treasury Currency Report will also be released on Friday, wrapping up the week.
If you'd like to discuss your foreign exchange requirements with one of our currency specialists, call us on +44 (0)20 3465 8200.