A change of key
View from the Trading Desk:
A change of key
While news headlines in the UK are all focused on Boris Johnson’s confidence vote this evening, in markets, the more subtle story of rate expectations is more important. At the tail end of 2021, the market began to factor in very dramatic hikes in US policy rates. Bloomberg’s measure of rate expectations for the December 2022 Federal Reserve meeting went from 0.33% at the beginning of Q4 2021 to more than 2.8% presently. In the intervening period, we’ve received a 0.25% and 0.50% hike in March and May 22, respectively, which argues that Fed voting members were indeed anxious to ‘normalise’ policy and bring rates to more historically defensible levels. This urgency was largely driven by escalating inflation pressures that the Fed and market pundits speculated might untether the central bank’s ability to control price stability via its main policy tools.
The other side of the coin was that while the initial jump in rates—and notably reduction in QE asset holding—was a natural correction, many expected a lower growth rate, and the nature of the inflationary pressures would curtail this hiking-zeal in the second half of 2022. After all, inflation of this variety—where reduced supply, not increased demand—is causing price increases, can only peripherally be managed by monetary policy. More plainly said, increased costs for goods were weighing on the economy, and tighter monetary policy was not going to fix it but would slow the economy too. All-in after a few sizable hikes, most expected the message would become more restrained and talks of 50 basis point hikes would turn into 25 basis point hikes, etc.
Bottom line: The hiccup comes when the risk of stalling economic growth remains, but the determination to hike is undiminished. Not only has the Fed’s recent speakers signalled a continued appetite for rate hikes—one laggard of main central banks—the European Central Bank has suggested it’s also under pressure to tighten policy faster than previously thought, despite myriad drags to growth. This tells us something important: the ECB probably thought the Fed’s appetite to normalize was limited and could countenance the policy rate differential. The change in stance means that their expectation of this differential has changed—or perhaps of the Fed’s actual appetite—and they may need to take more aggressive action to keep it in check. The risk of a recession may have just subtly increased along with the Fed’s normalising ardour, and no one noticed.
The week ahead
Sterling has been a relative under-performer over the last week, down 0.73% against the US Dollar making it one of the worst performers in the G10, being beaten only by the Japanese Yen. The Pound has started this week off strongly, despite news that UK Prime Minister Boris Johnson will face a leadership vote around 6pm today. This is likely due to the market being fixated on the Bank of England and inflation. Seven rate hikes are now priced in for the next 12 months, with base rates for March 2023 moving 50 basis points higher in recent weeks following further negative commentary from the central bank.
- The British Retail Consortium will release the Retail Sales Monitor y/y data for May tomorrow, analysts are expecting a 0.2% print.
- The UK Construction PMI is forecast to read 56.6 in May versus 58.2 in April.
- For May, the RICS House Price Balance is expected to come in at 76% compared with an 80% print in April.
- Consumer Inflation Expectations for the next 12 months will be released on Friday.
Consensus for upside in the common currency is building as the war in Ukraine becomes less of a driver and the market starts to look to the European Central Bank for a more hawkish monetary policy path. Bank of America is expecting the ECB to raise interest rates by 50 basis points in both the July and September meetings. ECB President Christine Lagarde has maintained the need to have optionality in the bank's strategy to fight inflation but a lack of forward guidance or contradictory messaging could put the bloc on course for a situation similar to the Bank of England. European markets are trading higher this morning following a strong close in Asia.
- German Industrial Production m/m for April is projected to grow 1.2% versus a 3.9% contraction in March.
- The European Central Bank will be meeting this Thursday to provide its latest monetary policy statement along with any updates to the main refinancing rate.
- Italian Industrial Production m/m is expected to contract by 1.1% in April.
- German Bundesbank President Joachim Nagel will be speaking at 4pm on Friday.
The US Dollar Index has ticked around 10 basis points lower this morning as a risk-on mood sweeps through markets following strong gains in Asia with S&P 500 futures pointing 1% higher. Market pricing is still leaning to a continuation of the current path of interest rate hikes by the Federal Reserve with Lael Brainard affirming her position on the need for weaker Consumer Price Index prints before reassessing policy. Hedge funds have positioned bets for the US 10-year bond yield to move above 3%, going short the underlying bonds, ahead of the CPI print for May on Friday. Elsewhere, WTI is holding below $120 per barrel as US President Joe Biden heads to Saudi Arabia.
- The US Trade Balance for April is projected to read -$89.5b versus -$109.8b in March.
- Initial Jobless Claims for the week ending June the 4th are forecast to come in at 206K compared with 200K the week prior.
- The Consumer Price Index (CPI) m/m is expected to rise by 0.7% in May taking year-on-year inflation to 8.3%.
- Preliminary University of Michigan Consumer Sentiment looks likely to read 58.3 in June, little changed from the May reading of 58.4.
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