Weekly Brief

It’s a recession, technically speaking

29 July 2022

GBP

Aside from the ongoing battle to become the next Tory party leader, the newsflow has been pretty light in the UK over the past week. That is all about to change over the next 7 days, as the next BoE meeting should help to dictate the short-term direction for the pound.

The BoE have raised UK interest rates five times now since the end of last year, with three of the nine-member committee voting for a higher rate rise, than what was the eventual 25bps move on each occasion, for the past two meetings. BoE governor, Andrew bailey, has stated that a 50bps hike is ‘on the table’ going forward, as the BoE attempts to combat surging inflation.

As we have said recently, the decision for the BoE is a complex one. On the one hand, that surging inflation alone should prompt a bolder rate hike, given that the widespread higher prices are hurting the pockets of those who need it most. However, the higher interest rates then go, the cost of borrowing naturally accelerates, and the poorest will also be those who feel the pinch of each rate hike the most. Of course, the government themselves are paying nearly £20bn in interest rate charges on their debt each month, which will increase each time that the BoE hike, and for around a quarter of their debt, will also increase each time inflation rises. Tough choices indeed.

Whilst the BoE might be a tough one to call, the pound has fared somewhat better. GBP/USD now sits comfortably above 1.2000, which is a direct impact of that weaker dollar, however, GBP/EUR has also meandered back up towards 1.1950, which suggests more widespread sterling strength.

EUR

The latest inflation in Europe’s largest economy rose unexpectedly in July, driven by higher energy prices. German Harmonised CPI (HICP) increased by 8.4% (YoY), against an expectation of around 8.1%, from 8.2% in June. If you take out the harmonised* part, CPI actually fell slightly from 7.6% to 7.5% (YoY). However, given that Russia is now looking again at cutting the gas supplies through Nord Stream 1, inflation is likely to stay uncomfortably high in Germany and throughout Europe.

That will not be the case according to the good people at the IFO institute, who suggested that ‘prices may continue rising, but the tempo will slow. That means inflation has reached its highest point and will go down in the course of the second half of the year’. That would be a welcome relief, if achieved. Interestingly enough, the latest IFO Business Climate (Jul) which was released at the beginning of this week gave a rather downbeat look, with all components of the report missing estimates.

Next week is the turn of growth, with Q2 GDP set for release throughout the region. Euro area GDP growth is expected to have dropped from 0.6% (Q1) to around 0.2% (Q2), but more importantly, should remain slightly in positive territory.

As for the single currency, much like the pound, the Euro has fared better this week, against that positive sentiment backdrop. Having had the much-publicised battle around parity over the previous couple of weeks, EUR/USD has spent this week between 1.0100 and 1.0275.

*Harmonised inflation ensures that each nation within the EZ use similar calculating metrics for their inflation data, to ensure consistency throughout the region.

USD

Less than 24 hours after the Fed raised U.S interest rates by 75bps for the second month in succession, the latest growth figures confirm that the U.S economy has entered a technical recession. Preliminary GDP (Q2) slipped by -0.9%, on the back of a -1.6% print in Q1. When asked just a day before in his press conference immediately after the FOMC meeting, Jay Powell said that he did not believe that the U.S would go into recession. To be fair to Powell, there is every chance that the GDP reading will be adjusted further down the road. Whilst the jury might still be out on a recession, the chance of the U.S economy now being in the dreaded stagflation, look much higher.

The FOMC meeting itself went pretty much as expected, with Powell & Co sticking to script, and not being tempted to hike at a faster pace, despite surging inflation. Powell also confirmed that decisions on future rate moves will be judged on the incoming data, and therefore forward guidance will become obsolete. Whilst this may frustrate markets constantly desperate for clarity, it does give the Fed scope to make decisions on the day, and not be guided by their own guidance – if we can put it that way.

The difficult thing for markets now is determining how to react to that incoming data. Whilst it might sound counterintuitive, the worse that incoming data is, the less likelihood that the fed will then feel the need to hike rates so aggressively down the road, and therefore that is considered positive for markets.

That is exactly how that GDP print was interpreted by markets, with positive rallies in the main indexes, and a positive risk sentiment. As you will all know by now, that does not normally sit comfortably for the greenback, but the dollar index had a fairly flat session on the day. Perhaps currency traders had a different view.

Looking into next week, Friday sees the release of the July labor report, with an expected dip from 372k to around 260k on the headline.

CAD

Given that the bank of Canada (BoC) raised Canadian rates by such a big (100bps) margin during their last meeting, there is some speculation around whether they could consider such a bold move again going forward. With inflation still pushing higher, as well as a tight and robust labor market, it is still widely expected that the BoC will continue to hike rates over their next two meetings, but perhaps in those meetings at a slightly less aggressive pace. The latest market-implied estimates are currently priced for a 75bps move in September and 25bps in the meeting after. Not quite the 100bps going forward then.

Next week sees the release of the July employment report, and assuming that the labor market shows no signs of weakening, a strong report will help to solidify the belief that the BoC will keep to their plan.

There is often much fanfare from market participants at what the neutral* and terminal* rates are for any central bank, and in the case of the BoC, the terminal rate has been suggested at being around 3.5%, or 100bps from the current 2.5%. That would suggest that after the next two BoC meetings, the BoC may take a pause. Time will tell.

As for the Loonie, USD/CAD has trended lower over the past week, and after breaking back below 1.3000, reached a low of just under 1.2800 yesterday afternoon. GBP/CAD has moved from just under 1.5500, to just over 1.5600, reflecting that slightly stronger pound (see GBP).

The ‘neutral’ rate is considered the rate at which an economy is neither expanding or contracting, and is therefore completely subjective, as it is almost impossible to clarify. The ‘terminal’ rate is considered the final rate achieved at the end of any cycle.

AUD & NZD

The latest Australian inflation reading will give the RBA something to think about, as inflation increased to a 21-year high, during the last quarter. With energy and foods costs set to increase, there is every chance that we have not seen the peak of Australian inflation.

Australian Treasurer, Jim Chalmers, said himself that inflation will accelerate further ‘north of 7%’, higher than the RBA’s peak suggested for later this year. Chalmer’s is expecting lower growth, driven by global economic headwinds.

Next week should see another big rate hike from the RBA, with many analysts now homing in on a 50bps move, rather than 75bps. The reasons given are the less aggressive fed, and although Australian inflation is at a 21-year high, it is perhaps not quite as bad as it could have been, which are both helping to dampen expectations somewhat.

As for the Aussie, well similar to the other crosses, has fared better against the greenback of late, moving back over 0.7000, having been on a constant rally since the middle of the month. NZD/USD has followed a similar path, moving back towards 0.6300.

 

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