Post date: 03/10/2022
The past week has been another extraordinary one in the foreign exchange market, with many currencies hitting new lows and volatility levels spiking to multi-year highs. The relentless rally in the US dollar, which saw it rise to a fresh two decade high on Wednesday, came to a halt in the second half of the week. Another surprise to the upside in Euro Area inflation data supported the common currency, as investors doubled down on bets that the European Central Bank could raise interest rates by another 75bps at its October meeting. Sterling also recovered strongly, after hitting a record low on the dollar last Monday, as the Bank of England leapt to the defence of UK bond markets that were battered following the recent budget announcement. Most emerging market currencies also recovered ground against the dollar in the second half of the week, led by the Chinese yuan, which rebounded off record lows following verbal intervention from the People’s Bank of China. Volatility levels among a number of major and EM currency pairs spiked to multi-year highs last week. This includes both the euro and sterling, which saw their 6-month implied volatility levels jump to 10- and 13-year highs respectively. Investors will be bracing for another hectic few days in financial markets this week, as attention pivots to a string of major macroeconomic data releases. We will be keeping a particularly close eye on revised PMI numbers out of the G3 economies (Monday and Wednesday) and, of course, Friday’s US nonfarm payrolls report for September. Meanwhile, focus in the UK will remain squarely on the fallout from the mini-budget. This morning’s announcement from UK Chancellor Kwarteng that the government would be scrapping its plans to remove the 45p tax rate has supported the pound, though we think that it is unlikely to have a lasting impact.
Sterling behaved like an emerging market currency suffering a crisis last week, as it continued to experience violent gyrations off the back of the recent budget. The pound actually ended the week as the best performer in the G10, with investors buoyed by news that the Bank of England plans to use its reserves to purchase unlimited amounts of gilts through to the end of October in order to allay the turmoil in bond markets. Whether this intervention puts a floor under sterling, or merely provides some short-term relief, remains to be seen. The BoE has already indicated that it is unlikely to deliver an emergency rate hike, and direct FX intervention is off the table, in our view, given the UK’s insufficient FX reserves (less than 2 months of imports). The government’s U-turn on the 45p tax rate is a positive sign for UK assets. We would, however, argue that sterling may not be out of the woods just yet, particularly given this only accounted for around 4% of the total cost of the tax cuts over the next two years.
A sizable surprise to the upside in Euro Area inflation data, which rose into double digits for the first time in September, supported the euro against most currencies last week. Unlike in the US, we are yet to see signs of a peak in price pressures in the common bloc. This reinforces our view that the European Central Bank still remains behind the curve in raising interest rates and will likely have to tighten policy into 2023 considerably more than its US counterpart – a medium-term bullish signal for the euro. In the meantime, expectations for the next ECB meeting later this month will be key for the common currency. Swap markets are now fully pricing in a 75bp rate hike, with a full one percentage point move likely to be in the cards should economic data in the interim come in above expectations.
Macroeconomic news out of the US was mostly bullish for the dollar last week, namely a sharp drop in initial jobless claims, and larger-than-expected increases in new home sales and personal spending. The US Dollar Index did, however, retreat from its 20-year highs amid a broad improvement in risk sentiment, and perhaps an element of profit-taking and month-end portfolio rebalancing. This Friday’s nonfarm payrolls report will be the highlight of the US trading week, with markets bracing for another solid month of jobs gains and positive nominal earnings growth. A handful of Fed members (Williams, George, Barkin et al) will also be speaking at the beginning of the week. We will be paying particularly close attention to their thoughts on the recent easing in US inflation data, and its ramifications for the size of the next rate hike at the November FOMC meeting.