Weekly Brief

Will the Fed pivot, pause or persist?

28 October 2022

GBP

It has been another week of relative calmness for the UK. Rishi Sunak and Jeremy Hunt took the decision to delay the medium-term fiscal plan from the end of this month until the 17th November. They will use the extra time to crunch the numbers with the OBR, and ensure that there are proper outcomes factored into their assumptions. All of this clearly makes sense. The fact that for every day that passes, government borrowing costs have been reducing, which has ensured that the hole in the fiscal plans has already reduced by about £10bn to £30bn, may also be relevant. At this rate, If the government leave it long enough, there is a chance that they will be left with no deficit.

As we highlighted in our daily commentaries, markets have reacted with overwhelming positivity to the change in both PM and chancellor. The sell-off that the pound and UK gilts in the Truss/Kwarteng era underwent has now been totally reversed, and replaced with a respectable ‘Rishi rally’ ensuring that gilt yields continue to move steadily lower, and GBP/USD journeying beyond 1.1600 for a spell through this week.

On the data front, the accelerating weakness in the UK economy is become ever-more apparent, with the latest PMI survey reflecting softening across the board, as the key services PMI dropped to 47.5 from 50. Next week is dominated by the BoE meeting, and whilst they will not have the benefit of the government’s updated fiscal plan to help guide their path, inflation is now running beyond 10%, and with everything else settling down, the BoE look likely to go with a bold 75bps hike. Quite whether the UK economy can withstand much more in the way of hikes beyond that is questionable.

As for the pound, and assuming that there are no more bumps in the road, sterling’s fortunes from here are far more likely to be driven from broader market appetite for risk. As we said at the top, GBP/USD has made a fantastic recovery from the 1.0300 low, but much of that is down to a recently weakening dollar (see USD). GBP/EUR popped back up to 1.1600 yesterday, as profit-taking from long EUR positions after the ECB drove the single currency lower.

Thoughts from the dealing desk

“The story of the start of the week was dollar weakness on speculation that the Fed will slow down their pace of rate hikes from December onwards, however the story at the end of this week is the same for the ECB and euro. On Monday the markets were pricing-in, according to the interest rate swaps market, a peak in the main ECB rate of 2.9% in September 2023 however after President Lagarde’s comments yesterday that has been marked down significantly. The markets are now expecting rates to peak at 2.6% in July 2023 and as a result we are seeing a weaker euro across the board. Today we have US PCE inflation and University of Michigan US Inflation expectations, which will both be key in determining how aggressive the Fed hike rates over the next few months and if they stay at elevated levels I would expect the Fed to signal next week that they are not yet done with aggressive hikes.”

-Jon Camenzuli , Corporate Dealer

EUR

It has been another disappointing week for Euro-area economic data, as the economy continues to struggle across the region. The latest batch of PMI readings reflected particular weakness in Germany, with the key composite and manufacturing components both missing estimates by some margin. The region-wide composite also missed estimates, slipping to 47.1 from 48.1.

As expected, the ECB raised Euro-area interest rates by 75bps yesterday (Thursday), which increased the key Rate on Deposit Facility to 1.5%, and brings rates up to levels not witnessed in a decade or more. As well as highlighting that the ECB will need to raise rates again over the coming months, ECB Head Lagarde also observed that the depreciation of the Euro has added to the region’s inflation problem. We often highlight how countries import inflation through weaker currencies. Similar comments have recently emerged from other key central bank heads. Lagarde also mentioned that ongoing tight monetary policy results in weaker global growth, which could lead to higher unemployment in the future.

Looking ahead, Lagarde reiterated that any decision on interest rates in the future will remain data dependent, and those decisions will be made on a meeting-by-meeting basis, comments she has said on more than one occasion previously. The single currency had been moving steadily higher leading into the ECB meeting, culminating with EUR/USD moving as high as 1.0100, as markets positioned for that hefty rate hike. However, profit-taking and broader market caution, resulted in a sight pullback through parity yesterday afternoon. Next week will also key for data, as the latest inflation and Retail Sales data are published, with the former expected to highlight just why the ECB need to maintain their current pace of rate hikes. 

USD

Having risen in such spectacular style throughout the year, the dollar has been subject to a fairly rapid decline over the past week. A combination of factors have probably helped to fuel the decline. In particular, a recent article from the WSJ, suggesting that the Fed might be about to reduce the level of future rate hikes certainly helped. Any story from the WSJ gets the attention of the market, given that they are rumoured to be the Fed’s preferred outlet to circulate stories during their self-imposed ‘quiet’ period ahead of impending FOMC meetings.  

Weaker US data has also helped, with another batch of soft housing data, as well as confirmation that the 30-year ‘average’ fixed mortgage rate has now risen beyond 7%. A big drop in the latest Home Price Indices further cements the bleak outlook, which is no surprise given the size and frequency of those Fed hikes. The latest Durable Goods orders also highlighted weakness, rising by 0.4% (MoM/Sep), against an expected jump of 0.6%.

On the plus side, initial readings of Q3 growth beat estimates, with a 2.6% jump versus 2.4% expected. However, on balance, the disappointing data has helped to drive risk assets higher, and this has also contributed toward the weaker dollar. The dollar index (DXY) has now fallen from near 114.00 to 109.50 over the past week. The BoJ must feel quite happy with the timing of their most recent intervention in USD/JPY, given that the pair is now down below 147.00, having been firmly over 151.00 this time last week. Timing is everything.

Looking ahead, next week’s FOMC meeting will be key to see whether there has been any change of stance from the Fed. Whilst another bumper rate hike has been fully priced into markets, as always, it will be about what the Fed say regarding the path for future rate hikes that markets will focus on. Beyond the FOMC, the October employment report on Friday will also matter.

CAD

Increased chances of a recession in Canada prompted the BoC to raise rates in Canada by ‘only’ 50bps earlier this week, moving Canadian rates up to 3.75% in the process. Given the stronger than expected inflation reading previously, markets had been split on whether the BoC would hike by 50 or 75bps.

Speaking after the announcement, BoC head Tiff Macklem, suggested that this phase of tightening is drawing to a close, although the BoC are not there yet. He went on to say that this decision ‘will depend on how monetary policy is working to slow demand, how supply challenges are resolving and how inflation expectations are responding.’

The cautious approach has been fuelled by increasing risks of a recession in Canada, with Macklem highlighting that a couple of quarters of slightly negative growth is just as likely as a couple of quarters of positive growth.

The Loonie shrugged off the more cautious BoC, with USD/CAD moving back to test muted support at 1.3500 by the end of the week, which is consistent with those gains for currencies elsewhere against the greenback. Looking ahead, next Friday’s employment report will be key to see whether there are any signs of weakness emerging in the labor market.

AUD & NZD

The latest inflation report in Australia highlighted that inflation has now reached a 32-year high over the past quarter. CPI jumped by 1.8% during Q3, exceeding estimates of around 1.6%. The annual increase jumped from 6.1% to 7.3%, which is the highest level since 1990. Increases in home building and gas prices were major contributors to the big jump. Inflation is now running at three times the pace of wage growth which will give the RBA much food for thought, given that they were positioning for a much slower pace of hiking rates. The RBA have raised rates by 250bps since May.

The chances of a more aggressive RBA helped to underpin the rally in the Aussie over the past week, with AUD/USD moving back over 0.6500 for the first time in nearly a month. The kiwi followed suit, with NZD/USD moving back over 0.5850. Next week’s Australian Retail Sales data and the latest RBA Monetary Policy Statement will be key, as well as the latest employment report from New Zealand. Overall unemployment is expected to fall below 3% over the last quarter.  

 

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