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Fed hawk’s letting the dollar fly

Pause, hike, cut. The dynamics of Fed pricing. Mood darkens in Germany and the pound’s bipolar reaction to CPI.

Pause, hike, cut. The dynamics of Fed pricing

The Federal Reserve’s decision to continue or end the current tightening cycle hinges on the economic data, as governor Waller said in his prepared remarks at an event in California yesterday. The next three weeks will therefore be crucial for determining the future path of the interest rate, especially against the backdrop of a divided committee.

The minutes from the last FOMC meeting, published yesterday, gave us an insight into the Fed’s decision making to hike rates for the 10th consecutive time. While several members said that continued tightening would not be necessary, another camp emphasized that the slow disinflationary process would warrant further rate hikes. The current macro environment, all else being equal, could justify a compromise of pausing the hiking cycle while maintaining a hawkish bias under the condition that inflation turns out more sticky than expected. The market took notice and investors pushed up their expectations for the fed funds rate.

Markets are now expecting the Fed to (1) pause in June, (2) hike in July and (3) cut rates in September. But the easing expectations for 2023 have been pushed down significantly to just two rate cuts being priced in. The US dollar followed Fed pricing higher and appreciated against the euro, yen and pound, reaching the highest level since December 2022.

Chart: Not as many cuts as expected. Fed: Priced hikes/cuts for the next 12/24 months.

Mood darkens in Germany

Europe’s largest economy and the world’s third-largest exporter has been hit by a global demand slump. While having recorded a much better winter than economists had expected, Germany is heading into the summer with a load of skepticism.

The six-month outlook worsened for the first time since October, according to Germany’s leading economic indicator published by the Ifo institute. The expectations sub-index fell from 91.7 to 88.6, a level normally associated with recessions. The ZEW institute’s investors’ confidence index also fell for a third month, showing the impact of the waning Chinese reopening and the debt crisis in the US taking a toll on sentiment. Today’s release of first quarter GDP confirmed the recent macro data and our suspicion, that Germany fell into recession, following two consecutive quarters of negative economic growth. Over the last 12 months, the German economy shrunk by 0.5%, recording a 0.3% contraction in Q1 alone. France is coping a bit better with external headwinds, but the French manufacturing sector has also fallen into recessionary territory, according to the purchasing manager index published on Tuesday.

Given the hawkish re-pricing in the US following the meeting minutes and the deteriorating macro outlook for the Eurozone, it is no wonder that EUR/USD has lost momentum. The currency pair is on track to record three consecutive weekly depreciation, closing in on the $1.07 level.

Chart: Germany falls into recession after all. Germany: Ifo manager survey and GDP growth.

The pound’s bipolar reaction to CPI

With the UK now facing the highest core inflation rate within the G7 countries, markets are expecting the Bank of England to continue raising its benchmark interest rates as much as three times. Still, the negative reaction of the pound following the CPI release highlights, that stagflationary risks have increases. Higher inflation means higher for longer interest rates, which would translate into lower growth and a weaker pound. So, how sticky is UK inflation going to be?

Most leading economic indicators would suggest that price pressures are starting to peak. Commodity prices have already slid into negative territory on a year-to-year basis, with food prices starting to roll over. It is still difficult to tell a right from a wrong signal when it comes to inflation, as food prices fell year-on-year in January 2023 just for them to climb back again to an all-time high in March. However, the slump in core producer inflation, which has fallen from 14.7% in June to 6% in April, has been welcomed by policymakers. The transmission from falling broader inflation measures to weaker core inflation rates will take time. But the factors that have driven price pressures during the past two years have definitely waned.

The pound, like the euro, is on track to record a third weekly fall in a row. GBP/USD is coming off a multi-month high at $1.2680 and has since then fallen by 2.5%. The upward trend that has been in place since September could be tested if the pair falls below $1.2260 amidst the worries over a debt default by the US government.

EUR/USD at the bottom of its 7-day trading range

Table: 7-day currency trends and trading ranges

Table: Rolling 7-day currency trends and trading ranges.

Key global risk events

Calendar: May 22-26

Table: Key global risk events calendar.

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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.

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