Economic Update

Middle East conflict escalation increases FX and energy risks

The conflict in the Middle East continues to intensify, with the US and Iran exchanging fire again over the weekend.

According to US Central Command, the US conducted further strikes against military facilities, air defense systems, drone launch facilities and coastal surveillance outposts.

Iran targeted US bases in the Gulf and also carried out missile and drone launches against Jordan, Bahrain and Kuwait, as well as shipping in the Strait of Hormuz. US military casualties continue to rise, while Iran has claimed, in unconfirmed reports, that the US is targeting civilian infrastructure.

Oil prices have surged again, but FX markets and bond yields have been affected far less than might have been expected, at least so far. The risk of a renewed supply chain crisis remains a downside risk to global growth, in my view.

US Fed rate hikes back on the table according to markets, but are they really?

Recent market pricing suggests that a Fed rate hike has come back into focus. However, signals from the Fed itself continue to indicate that an extended period of unchanged interest rates remains the most likely outcome.

There has been some turbulence in equity markets, with doubts emerging around further capital expenditure programs linked to AI. The prospect of higher interest rates from the Fed would further undermine the case for increased investment.

There are no major US releases due this week and the Fed is now in its communications blackout period ahead of next Wednesday's decision. Upside risks to inflation cannot be discounted, but weakness across parts of the domestic economy suggests there is limited support for a further rate hike. In my view, the more likely outcome is that the Fed remains on hold for a prolonged period until the fog clears.

CAD CPI and retail sales releases due, Mexico waits on unemployment

This week's Canadian CPI figures for June and retail sales data for May are unlikely to alter the economic narrative materially, if at all. Canada continues to face imported inflation pressures, but also weak domestic activity, a combination that constrains the Bank of Canada's policy options, in my opinion.

The upside for CAD therefore appears limited. However, the recent rally could extend by a further 1% or so, while upside risks remain around 2-3% from current levels. The Bank of Canada is expected to remain on hold when it meets next week.

Meanwhile, Banxico does not meet until the first week of August. The risk remains that the central bank cuts interest rates further, which could place renewed pressure on the MXN. Attention will also focus on incoming data before that meeting, including June unemployment figures.

I continue to see upside risks for USDMXN should Banxico ease policy again. Such a move would run against current policy expectations among most major central banks. It will be interesting to see how Banxico proceeds.

Packed UK calendar starts with Burnham speech today

This week brings a substantial run of UK economic releases, including public finances, labor market data, CPI and retail sales figures, alongside consumer confidence and PMI surveys.

These data points could prove consequential for the new Prime Minister in terms of the scope available to influence the direction of both the economy and the country.

Prime Minister Andy Burnham is scheduled to deliver a speech in Downing Street today. However, he will not address Parliament as it is now in recess until early September.

The speech is unlikely to have a significant market impact, whereas the data and survey releases present greater scope to interrupt the recent GBP rally than to sustain it, in my opinion.

Markets and the government should pay particular attention to the public finances and labor market data.

ECB meeting and Euro surveys in focus

The ECB meets on Thursday and is expected to leave interest rates unchanged ahead of its summer break. Markets are likely to place greater weight on the ECB's post-meeting communication than on the decision itself, as policymakers may use it to prepare markets for tighter policy when the ECB returns from its summer hiatus.

However, the challenge for the ECB remains the conflicting pressures of stronger imported inflation and weaker domestic activity. This week's surveys, including the German ZEW survey and PMI releases, are unlikely to support the EUR or strengthen the case for higher euro area interest rates, in my opinion.

Meanwhile, escalating conflict involving Russia-Ukraine and US-Iran could prove unhelpful for economic activity while pushing inflation higher in the short term. Supply-side constraints are becoming an increasing concern for financial markets and European governments, in my view.