Written by George Vessey & Boris Kovacevic
Strong data, high yields, attractive dollar
More than one and a half years ago when the Federal Reserve (Fed) started one of the most aggressive tightening cycles in the institution’s history, it was not clear how many interest rate increases would be needed to cool down an overheating US economy. Eleven rate hikes worth more than 500 basis points later and the largest economy in the world is still running at an estimated annualised growth rate of around 4.9%. And while the slowdown of inflation and the cyclical parts of the economy – manufacturing and housing – have elevated the pressure from the Fed to continue tightening policy, markets are currently only expecting rate cuts worth 75 basis points for the entirety of 2024.
Last week’s macro data does not indicate that a recession is imminent in the US. Inflation on an annual basis rose for the second month in a row from 3.2% to 3.7%, while both producer price inflation (0.7% actual vs. 0.4% expected) and retail sales (0.6% actual vs. 0.5% expected) beat economists’ expectations. It is not hard to see why interest rates, particularly on the long end of the bond curve, have been rising against such a backdrop. The 2-year yield is trading back above 5% with the 10-year US yield approaching the highest level since 2007 at 4.4%.
The US currency has broadly benefited from US exceptionalism and higher rates and has managed to record eleven consecutive weekly gains against its peers on a trade weighted basis. For the dollar to remain attractive to investors at such valuations and against the backdrop of the Fed likely ending its tightening cycle, rate cutting speculations would have to remain subdued. We are therefore looking forward to this week’s macro data and the FOMC meeting, where no rate change is expected.
ECB hikes against all odds
The weakening of the European economy against the backdrop of a slowing industrial sector and higher global interest rates has not been enough to convince the European Central Bank (ECB) to pause its tightening cycle. With inflation expectations still trading near all-time highs and the recent CPI prints coming in, at, or above expectations, policymakers decided to raise the deposit rate to an all-time high at 4% last Thursday. While some Governing Council members were advocating for a pause, the broad majority has been behind the decision, according to Christine Lagarde.
The sharp fall of the euro below $1.07 to $1.0660 following the rate decision can be interpreted as the markets believe 1. the ECB is going too far in its fight against inflation given weak underlying growth and 2. that the overtightening in the short term will have to be compensated by more easing in the medium term. While ECB president Lagarde has indicated that this would be the final rate increase, some policymakers have already started pushing back against such a narrative.
Governing Council members Vasle and Holzman made sure to leave the option of another hike this year on the table. However, only stickier-than-expected inflation and an uptick in the global business cycle will convince markets to price out the rate cutting expectations for 2024. This is why the release of Flash PMIs for the services and manufacturing sector on Friday will be crucial to watch. Not only are these data points one of the most important leading indicators for the Eurozone economy, the PMI’s are also the first data point we will be getting for the September, the last month of the third quarter.
BoE hike could be its last
GBP/USD is grappling with $1.24 this morning ahead of a huge week of key central bank meetings that could inject a fresh bout of volatility across financial markets. The Bank of England (BoE) is expected to hike by 25-basis points, but we acknowledge the risk of a potential pause before a final hike later this year instead.
With UK wage pressure still strong and markets pricing a 75% chance of a hike, we think it’s more likely the BoE will raise Bank Rate to 5.5% this Thursday and recent communications from policymakers have done little to push back against this view. However, waning momentum in economic activity, a further cooling of the labour market and growing disinflationary signals mean there’s a strong case for pausing soon. August’s inflation numbers are published on Wednesday, and this could be influential to the overall rhetoric used in the press conference after the decision. A dovish hike like we saw by the ECB last week could drag sterling lower, with $1.23 eyed against the US dollar and €1.15 possible against the euro. A surprisingly hawkish hike would probably support sterling though and prevent a continuation of its recent depreciation.
Already we’ve seen the pound fall around 5% against the dollar since July, which correlates with markets scaling back BoE rate expectations from a predicted peak of 6.5% to 5.5% over this same period. More downside risk in the near-term is possible though given the lack of rate cuts priced in for 2024.
Commodity currencies bolstered by rising energy prices
Table: 7-day currency trends and trading ranges
Key global risk events
Calendar: September 18-22
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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.
