Weekly Brief

Eight quarters of recession

04 November 2022

GBP

The Bank of England (BoE) surprised markets yesterday (Thursday), however, the surprise was not their 75bps rate hike, but their particularly dismal outlook on prospects for the UK economy, as they forecast a long recession ahead for the UK, as part of their updated forecasts. Furthermore, the BoE issued some particularly strong guidance accompanying this rate hike, suggesting that UK rates will not need to rise much further to bring inflation back to their 2% target. ‘We can make no promises about future interest rates, but based on what where we stand today, we think that (interest rates) will have to go up by less than currently priced into financial markets.’  

BoE governor Andrew Bailey was at pains to observe that this is important, given that rates on new fixed-term mortgages should not need to rise as much they have done. Market-implied probability for future UK rate hikes was quickly adjusted on that line. Indeed, long-term mortgage rates have also subsided somewhat over the past week, a move which is likely to continue (for now) given the BoE’s insistence on a lower terminal rate.  

The pound accelerated its post-Fed decline, with GBP/USD slipping as low as 1.1155 on the session, before rebounding a touch. GBP/EUR slipped from over 1.1600, to around 1.1450. The move lower for sterling was probably fuelled (other than broad dollar strength) by the rather pessimistic outlook for UK economic growth from the BoE, with their forecasts predicting a painful recession likely to last as long as eight quarters, which if played-out, would represent the longest recession in the UK since the second world war.

Looking ahead, ongoing UK economic data will play a key role in determining market direction for UK assets, especially the next couple of inflation reports, to see whether the BoE are anywhere near being correct in their perception that inflation is likely to peak by the end of this year. However, with the UK economy already looking particularly soft, next week’s Q3 GDP reading will also be closely monitored.

Thoughts from the dealing desk

“Once again, this week has been a reminder to never be complacent in FX markets, because they will always out manoeuvre us. Just as GBP was gathering momentum and starting to edge higher, back-to-back Central Bank meetings on Wednesday and Thursday caused GBP to sell off significantly (primarily against the USD). Both the US and UK raised interest rates by 0.75%, however their future paths diverged – The US anticipating interest rates to be higher than expected in the long run, and The UK expecting them to be lower than predicted. As a result, GBP/USD went from the 1.16s to just below 1.12 in less than 5 days. So whilst the direction of currency is as vague as always, what is clear is that we could be looking at further negatives surrounding GBP, and clients are naturally putting in place a decent % of cover now to be protected if we do move lower.”

-Daniel Jones, Corporate Dealer

EUR

Despite those recent bumper 75bps rate hikes from the ECB, with the last being just a week ago (to 1.5%), the latest data has seen Euro area inflation pushing over the key 10% region, rising to 10.7% from 9.9% previously. That figure had already been a record high for the region. Inflation in Italy has now reached 12.8% (YoY), whilst Germany is not far behind at 11.6%. Think that is bad? Inflation in Estonia, Latvia and Lithuania is now above 20%. Ouch. Clearly those ongoing high energy and Food prices are the biggest drivers to those increases to headline inflation. Extract those as well as beer and tobacco from the mix, and the core harmonised reading is a far more digestible 5% or so.

On the plus side, growth in the region remains in positive territory (just), with a 0.2% increase from the previous quarter. However, that figure is way down from the 0.8% reading beforehand, reflecting the sharp slowdown in activity for the region.

On balance, it seems as if the ECB will need to continue to raise rates at the current pace (75bps) for the foreseeable future, as they attempt to contain surging inflation. ECB head Christine Lagarde, said as much this week. However, with big imbalances throughout the region, such as Italy’s debt to GDP ratio of 150%, as well as Spain having more than 75% of personal mortgages being of the tracker variety, each rate hike from here will become ever more painful for many.

As for the Euro, well the single currency slipped in-line with other currencies against the dollar after the FOMC on Thursday, with EUR/USD dropping back below 0.9750, having been near to parity in the morning beforehand. However, one look at GBP/EUR (see GBP) confirms that the broader Euro actually held-up far better.

USD

For a moment on Wednesday evening, it looked as though the Fed might be about to deliver what the markets were so desperately hoping for. At the same time as raising US rates by another 75bps, taking the rate to a range of 4 – 4.25% yesterday, the Fed included in their statement a line suggesting they will take into account cumulative tightening, policy lags and economic and financial developments, in determining the pace of future rate hikes. Sounds like a pause maybe? Perhaps not a pivot, but the language implied that the Fed might be discussing a re-think. Apparently not. Fed chair Powell was quick to dismiss any hopes of a change in heart from the Fed, suggesting that it would be ‘very premature to think about pausing rate hikes.’ Que market sell-off.

Powell also went on to warn that US rates would likely peak at a higher level than previously had been expected, saying that ‘data since our last meeting suggests that the ultimate level of interest rates will be higher than expected.’ Markets have been quick to re-price the Fed’s likely terminal rate in the immediate aftermath. On the positive side, Powell did hint that the pace of hikes in the future could be smaller, suggesting ‘that time is coming, and it may come as soon as the next meeting, or the one after that.’ He also implied that the Fed will not need to see a series of lower inflation readings to switch to smaller hikes. That bit really matters, given just how sticky inflation has been.

Markets will now go back to data-watching, with a further two inflation readings (and the first one next week), before the next FOMC meeting, as well as two more labor reports, with the first one of those later today (Friday). A 200K increase is pencilled in for the headline payrolls by markets, down from last month’s 263K increase. However, there is every likelihood that ongoing robustness will be the order of the day throughout the October NFP.

As for the dollar, well the greenback was unsurprisingly the big winner this week, and has been quick to erode much of the pre-FOMC losses. Therefore, having moved to within a whisker of 109.00 at the end of last week, the dollar index (DXY) has since rallied back close to 113.00, highlighting those broad-based dollar gains.

CAD

Much the same as in the UK, Europe and pretty much everywhere else in the world, except perhaps the US just now, fears of an imminent recession have been gathering pace in Canada of late. The Bank of Canada’s surprising 50bps rate hike last week, when markets had been expecting a 75bps move, may have been driven in part by worries at the BoC that the Canadian economy is stuttering. At the same meeting, the BoC highlighted that they were getting closer to the end of their tightening campaign, which is technically correct of every central bank that has been raising rates, although that was perhaps not the point they were making.

The latest Labor market report, which is due for release later today (Friday), will be closely scrutinized to see if last month’s impressive 21k gains can be repeated, or if any weakness could be emerging. Indeed, the latest projections imply that the overall unemployment rate may have increased, albeit slightly, from 5.2% to 5.3% over the past month.

As for the Loonie, well USD/CAD followed the other main dollar crosses, and rallied sharply toward the end of this week. Having been as low as 1.3500 this time last week, the pair tapped 1.3800 yesterday. Looking ahead, USD/CAD will be impacted by both the US and Canadian employment reports, which are released at the same time later today. Beyond then, we need to keep a close eye on the price of oil, which has been creeping back up above the $90 region, and could still impact the Loonie, at least at the margin.

AUD & NZD

The RBA maintained its slower pace of rate hikes this week, raising Australian rates by a further 25bps, as they continue to battle inflation, against the backdrop of a weakening economy. Australian interest rates are now up at 2.85%, which is the highest level for nearly 10 years. The RBA said that inflation is now expected to peak at around 8% later this year, which is an increase on their previous forecast of 7.75%, and then (hopefully) decrease to around 3% by 2024. The Aussie rallied for a spell earlier in the week, with AUD/USD briefly tapping 0.6500, but the gains were short-lived, with the pair slipping back under 0.6300 by the close of play yesterday (Thursday).

The big news from New Zealand this week was in the shape of the latest employment report, with unemployment remaining steady at 3.3%. Both the labour force participation rate and employment rate rose to their highest respective levels since 1986. NZD/USD moved back above 0.5900 for the first time in nearly two months on the news, but much the same as the Aussie, was unable to sustain its gains against the greenback, slipping back to below 0.5800.

 

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