Proud pound awaits inflation data
The pound is the best performing major currency year-to-date but has slipped modestly against the US dollar and euro since the start of the week following last week’s surge higher. Nevertheless, the pound remains attractive amidst a sharp rise in monetary expectations as short-term rates extend to their highest since 2008, with average UK two-year mortgage rates topping 6%.
Based on current monetary expectations, UK interest rates should record a net increase of nearly +140 basis points (bps) by December against just under 60 bps in the Eurozone and -1.5 bps in the US. This differential in monetary momentum largely contributes to the renewed attractiveness of the pound among investors. Why the shift in expectation? Because the UK economy faces a more unique inflation problem than its neighbours and other major economies. Not only has the rise in prices been harsher following the war in Ukraine, but the deflation of prices is much slower than elsewhere. Although it is unclear how much of Britain’s inflation premium over other countries represents a time-lag rather than persistent inflation pressures, the BoE remains concerned at the stickiness of core inflation – which excludes energy and food – rising to 6.8% in April, its highest since 1992.
This will be the main focus of tomorrow morning’s UK inflation report and another upside surprise could prompt calls for a 50 bp BoE hike on Thursday, which could further support sterling demand. Moreover, the current risk-on climate amid the dollar’s recent slump and low volatility environment also benefits sterling – shown by the recent strengthening correlation of GBP/USD with the benchmark US equity index.
Euro shrugs off cooling German producer prices
Last week we saw wholesale prices in Europe’s largest economy fall for the second month in a row by 2.6% during the last twelve months, and data this morning showed German producer prices slowed from 4.1% in April to 1% in May – the lowest level since January 2021. EUR/USD remains above $1.09 though and GBP/EUR has slipped back under €1.17.
While this data point is considered a secondary one and therefore not particular market moving, it does add to the narrative that consumer prices will fall more sharply than the European Central Bank currently projects. Markets are expecting European policymakers to conclude the tightening cycle after nine hikes at a deposit rate of 3.75% and given high core inflationary pressures, this seems likely. However, with the Fed pausing and inflation continuing to cool, it will be hard to surprise the consensus to the upside when it comes to the policy path. This surprise to the downside in German producer prices could thus keep a cap on further upside for the euro in the short-term.
As we have noted previously, the main force driving EUR/USD higher has been the anticipation of rate cuts by the US Federal Reserve. These have been priced out, leaving the euro without a major catalyst in the short-term. For the currency pair to prosper going forward, policy easing bets would have to gain traction again and the Chinese recovery will have to speed up. That said, rate hikes in the UK, Norway and Switzerland this week should keep the common currency supported.
Inertia of FX could further hurt JPY
FX volatility around the world – both in the developed and emerging markets – remains highly subdued and has paved the way for a slightly more constructive risk environment, with stocks climbing and low yielding currencies, like the Japanese yen, on the backfoot.
Expected and realised currency volatility has fallen back to pre-Ukraine invasion levels seen in early 2022. This has been helped by the Fed’s recent decision to take a pause in interest-rate hikes, causing US Treasury yields to consolidate and the US dollar to slide. The global tightening cycle is nearing its peak and against a backdrop of cooling inflation conditions, the probability of larger-than-expected rate hikes or an upwards reassessment in terminal rates has dramatically reduced. This low volatility climate could further spur carry trades – converting low interest rate currencies like the Japanese yen into higher-interest rate currencies. The Bank of Japan’s commitment to loose monetary policy makes the Japanese yen an appealing funding currency for carry trades, which increases the risk of it building on its recent seven-day depreciation of over 3% against major peers. GBP/JPY, for example, has recently surged to levels last seen in 2015, whilst EUR/JPY to levels last seen in 2008.
Moves in currency markets have been dominated by central bank policy but the world must still contend with the long and variable effects of monetary tightening and liquidity will likely remain tight. Moreover, as the disinflationary process ensues, it will be more relevant to look at real interest rate expectations. The US dollar, for these reasons, may remain the preferred currency of choice going into the second half of 2023 if rate-cut bets remain off the table.
JPY over 3% lower in last seven days
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.
