Caught between a rock and a rock

Today's news headlines:

  • Powell suggests Fed embarking on 1990s-style mini easing cycle'. The Federal Reserve's interest rate cut has been dubbed a 'mid-cycle adjustment', just like in the 1990s. Fed Chair Powell suggested the move is not the start of a large easing cycle and instead is designed to maintain the economic expansion and lift muted inflation. (Bloomberg)
  • 'Johnson doubles UK spending on no-deal Brexit preparation'. The UK has signalled how serious the government is taking the 'do-or-die' Brexit stance by increasing spending on no-deal preparations. The total cash allocated is now 6.3 billion Pounds, including 1.1 billion to improve customs infrastructure and ensure access to critical medical supplies. (Bloomberg)

Being realistic

Yesterday we spoke about the murky results coming out of the Eurozone, and today we're set for fresh pain. Quarterly flash Gross Domestic Product (GDP) growth for the region registered a paltry 0.2% increase, and core inflation dipped just below the 1.0% figure forecasted. To put this in context, the ECB's inflation target is 2.0%, so we are miles away and falling at a pretty steady pace. Focusing in on the problem, manufacturing has long been a worry in the bloc and today's final Purchasing Managers' Index (PMI) readings are expected to validate these fears. Today will be the sixth consecutive month of contractionary readings in the sector, the worst run since mid-2013. Growth risks pointing to the downside are likely to cause the European Central Bank (ECB) to implement a sizable stimulus package in the next meeting in September.

Speaking of central banks, today's Bank of England (BoE) meeting is of considerable importance. It isn't about the policy rate, which is almost certain to remain at 0.75%, but about the Monetary Policy Committee's (MPC) forward guidance, which is expected to turn dovish. The salient factors for this change are the recent dip in the Pound and hardening Brexit rhetoric from Prime Minister Boris Johnson. In order to shift their stance, they'll likely have to ignore the potential for faster inflation caused by Sterling's circa 4.0% decline since May's forecasts. Instead, the focus will be on lower near-term growth projections where Q2 GDP is expected to drop to 0%. Based on the increasing likelihood of a no-deal, the shift in tone will bring them more in line with market expectations for future interest rate cuts.

Bottom line: Why should the BoE continue to assume a smooth Brexit will occur when the UK is three years down the line and no closer to an orderly departure? Markets have taken the realistic view of a messy divorce and what that would mean for the UK economy—almost certainly interest rate cuts and fiscal stimulus. The BoE could deliver a welcome surprise today and produce multiple forecasts based on differing Brexit outcomes, although that may be viewed as a partisan stance in this divisive issue.

Trump's election focus

Last night's Federal Reserve interest rate decision was pretty much as expected, but it still managed to upset quite a few market participants who want more than is ultimately possible. That's not to say to the Fed couldn't cut rates further, it could. It's already curtailing its balance sheet roll-off—the Fed hasn’t replaced maturating securities that were purchased during QE—which means it will be back in the market come September, buying $20bn of Treasuries per month. The Fed could go further and begin outright purchases of fresh securities, if it wanted.

What markets want from the Fed is for it to turn the tide, to return a measure of inflation to yield curve, to improve growth forecasts, etc. Monetary policy can't accomplish this in isolation. It has been said by the Fed, the ECB, and pretty much every central bank watcher in the markets. The central bank can reduce borrowing costs and support liquidity in the market to ensure business runs smoothly, without impediment. Via asset purchases, it can deepen the penetration of capital to riskier investments, by reducing the return on the constellation of safe securities. But these effects are already present; the Fed is only tweaking the settings at this late stage of the game.

Bottom line: The Fed is caught in a catch-22. While central bankers have made the point that fiscal policy must do the heavy lifting to stimulate the economy, when no fiscal help is incoming, they will eventually be forced to act anyway. And when the policy headroom (particularly outside the US) is so limited, the conventional wisdom is to act early and aggressively. Without a meaningful pick up in government spending, at some stage the Fed must abruptly change course and start aggressively cutting. Fed Chief Jerome Powell is learning just how difficult it is to communicate such an internally inconsistent message effectively.

GBP/USD

Overnight, the pair took a breather from Brexit related news and hit lows of 1.2101 following the Fed's insurance rate cut. Today, the main driver of the pair will shift back to domestic issues as the Bank of England (BoE) releases its latest inflation and growth reports at midday.

GBP/EUR

Both the Pound and the Euro felt the brunt of Dollar strength after the Fed's interest rate cut, meaning the pair has traded flat this morning. In today's session, it's the Pound that will likely drive the pair as the Bank of England takes the spotlight with its latest policy decision and reports along with Mark Carney's speech at 12:30pm.

EUR/USD

This morning, the pair reached two-year lows of 1.1032 while the Dollar Index climbed to two-year highs following the Fed's rate cut. European PMI data out this morning may provide some relief for EUR/USD, but the overpowering force will likely be Dollar strength after the Fed's latest monetary policy decision.


All content is written by the Global Reach Trading Desk. The opinions expressed are not the view of Global Reach Group and are not intended as investment advice.