The new central bank hierarchy
A central bank dominated macro week has produced substantial volatility in currency and bond markets, of which the latter continues to go against the optimism currently priced into equity benchmarks. The two important takeaways from last week’s rate decisions have been, that the fear of missing out (on AI) has seen stocks defy the bond markets higher for longer narrative and most importantly for us, that monetary policy continues to play a principal role in explaining and driving FX movement.
Investors have divided central banks into separate categories following the recent policy meetings and macro releases. The tight labor market and high inflationary regime have put the Bank of England on top of that hierarchy, with markets pricing in an 80% probability of interest rates reaching 6%. The BoE is followed by the European Central Bank, which is expected to continue last week’s hike with one in July and possibly the final one in September. The Federal Reserve has decoupled itself from its hawkish colleagues and left rates unchanged on Wednesday, switching into a more neutral stance in assessing the damage of the tightening cycle to the real economy. At the other side of the spectrum lie the Bank of Japan (neutral to dovish) and Peoples Bank of China (dovish), with the latter having decreased its benchmark policy rates by 10 basis points last week.
This hierarchy has reflected recent FX movements as well, with demand for currencies being supported by a hawkish central bank rising versus their peers. The euro has appreciated against the dollar to above $1.0970 following last week’s policy divergence of the hawkish ECB vs. the cautious Fed. Plotting the common currency against the yuan and yen shows just how much the monetary divergence theme has impacted currencies of dovish central banks. EUR/JPY has appreciated by 20% in the last 14 months, rising above ¥150 and reaching the highest level since 2008.
US recession probability splits asset classes
The upcoming economic week will mostly be important because of some secondary data points for the United States, the release of the purchasing manager indices for major economies for the month of June and rate decisions in Central- and Eastern Europe and the United Kingdom. Some assumptions broader markets have been working with for a couple of weeks now might be put to the test.
Large tech companies have benefited from the recent string of artificial intelligence adoptions and AI related news have, with the ten largest stocks in the S&P500 making up around 85% of the benchmarks year-to-date gains. The Fed’s first rate pause in 15 months has contributed to the optimism surrounding risk assets across the world, with the German DAX having risen to a record high on Friday. While bond investors have pushed out their expectations for the first rate cut by the Fed from September to January in only two months, policy easing is still expected at every meeting but one next year.
Stock and bond market positioning has clearly diverged in recent weeks, and so have views on Wall Street surrounding the probability of a soft landing. The last four recession in the United States have all been preceded by circumstances that are currently in place: (1) a tightening cycle of the Fed (2) recession probability rising above 30% (3) CB Leading Economic Index falling below -5 (4) >50% of US yield curves inverting. However, so far, the economy has held up better than expected, leaving room for stock investors to give the economy the benefit of the doubt.
BoE unlikely to push back against rate expectations
The British pound staged a 2% rally versus the US dollar last week, its largest weekly rise in six months, and is currently hovering near 14-month highs atop $1.28. Its 200-week moving average, located at $1.2877, is the next upside target of interest as market participants await critical UK inflation data on Wednesday ahead of the Bank of England’s (BoE) interest rate decision on Thursday.
Although we doubt the BoE will endorse the market pricing of almost six more rate hikes, we don’t think it will choose to push back heavily either amidst the tendency of inflation data to come in above expectations. Markets have interpreted the latest wage and inflation surprises as requiring a significant monetary policy response by the BoE and we expect a 25-basis-point rate hike this week as the base case scenario with vague guidance on what’s likely to come next. The negative repercussions of surging interest rates, such as a prolonged mortgage crunch, increased recession risks and job losses, are currently being overshadowed by the divergence between US and UK rate expectations when it comes to the impact on the value of the pound. GBP/USD is likely to hang onto recent gains and possibly extend beyond $1.30 if the BoE does not push back against tightening expectations, especially if inflation remains stubbornly elevated.
As we head into summer though the UK inflation story is expected to cool with food inflation expected to ease back in line with producer prices, while services inflation should come under less pressure now gas prices are so much lower. But for now, the BoE appears to be backed into a corner and this should remain supportive for sterling. Meanwhile, Britain’s main manufacturing trade body, Make UK, has today revised higher its outlook for 2023 but still expects production to fall over the year as companies face continued disruption and increased costs at home and abroad.
Pound at the top of its 7-day trading ranges
Table: 7-day currency trends and trading ranges
Key global risk events
Calendar: June 12- June 16
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*The FX rates published are provided by Convera’s Market Insights team for research purposes only. The rates have a unique source and may not align to any live exchange rates quoted on other sites. They are not an indication of actual buy/sell rates, or a financial offer.
