Post date: 01/08/2022
The US economy now meets the barest technical definition of a recession, and Federal Reserve hikes are now fully dependent on inflation and labour data meeting to meeting. This realisation brought down yields in the US sharply and they in turn knocked down the dollar against nearly every major currency worldwide, save the euro, which continues to suffer from the slow but steady reduction in the flow of Russian gas. The week’s winners were Latin American commodity currencies, led by the Brazilian real, up almost 6% against the dollar. Now that both the Federal Reserve and the ECB have effectively removed forward guidance, central bank hikes are more data dependent than ever. Therefore, focus will be on Friday’s labour report out of the US. So far, the jobs market there has remained remarkably resilient to the economic slowdown. The Bank of England meeting on Thursday is expected to deliver a 50-basis point rate increase, and it too is likely to downgrade or remove altogether any explicit forward guidance on rates.
Sterling continues to move mostly in line with risk assets, and last week’s stock rally buoyed it to the top of the G10 rankings, well ahead of both the dollar and the euro. The Bank of England meeting on Thursday is now front and centre for the pound. As of Friday close, interest rate markets were largely, though not fully, pricing in a 50-basis point move, with some investors betting on a 25bp hike. Therefore, it is a solid bet that Thursday trading will be volatile. We think it will be difficult for the MPC to buck the hawkish trend among G10 central banks and expect the larger move, with a consequent rally in sterling as a side effect. This rally may, however, be dependent on the voting pattern among policymakers, and the tone of communications in the bank’s latest Inflation Report.
Eurozone inflation once again surprised to the upside, validating our view that ECB interest rate hikes have considerably further to go than interest rate markets seem willing to accept so far. However, the inflation print was overshadowed by the continued reductions in gas flow from Russia, and the announcement of various measures to reduce demand, which understandably are not viewed as euro positive. Markets mostly overlooked last week’s GDP data, which posted larger-than-expected expansion, in favour of the doom and gloom energy headlines. This will be a holiday week with limited news flow but expect traders to focus on the ECB economic bulletin on Thursday for further clarity regarding the central banks’ plans for further hikes.
While it is true that the US economy has printed a slight contraction in two consecutive quarters, we would not call the current economic backdrop recessionary. The unusual combination of stalling growth, full employment and very high inflationary pressures prompted the Fed to de facto withdraw all forward guidance at its meeting on Wednesday and announce that further moves will be data dependent. Friday wage and inflation data showed no sign that inflation is pulling back to desirable levels, and the high ECI employment cost index data bore increasing hints of a developing wage-price spiral. All in all, we think that market expectations of Fed rates peaking just under 3.25% are too optimistic. Markets now turn to Friday’s non-farm payrolls report out of the US, expected to show yet another month of healthy job gains in a context of full employment. We will be paying close attention to the wage numbers for confirmation of the above-mentioned feedback between higher prices and higher wages.