The significant positive surprise in US inflation numbers for June sent financial markets roaring higher on expectations that the Federal Reserve is very close to ending its rate hike cycle. US rates dropped sharply, hikes beyond July were priced out, and unsurprisingly the dollar lost ground against every major currency worldwide, as investors cheered and risk assets soared. The week’s winners were the Scandinavian currencies and the Swiss franc, all of which were buoyed not only by the dollar’s fall, but also by extensive short covering. The market reaction to the inflation news was completely understandable, although we do wonder if the dollar has fallen too far, too fast. This week should see subdued summer trading in FX markets, with limited news on tap. The UK inflation report for June out on Wednesday will be key for sterling, but also the euro. It remains to be seen whether the disinflationary trends evident in the US will be replicated soon in Europe, and this report should offer some insights.
Sterling soared higher against the dollar last week in line with every worldwide currency, though it lagged a bit against the euro, and most G10 currencies for that matter. This can perhaps partly be explained by valuation, as sterling was already trading at very lofty levels given the extent of its year-to-date rally. High interest rates and better than expected economic data continue to support the pound, notably ongoing signs of elevated wage pressure, which remains around record highs. The May GDP print also outperformed expectations (-0.1% vs. -0.3% consensus), despite the negative impact of the additional bank holiday due to the King’s coronation. Mercifully, worker strikes are beginning to become slightly less onerous, as the number of days lost in May fell to its lowest level since mid-2022. The key number for sterling will, however, be the June inflation report out on Wednesday. Markets are expecting a drop in the headline number and a stable core index, which we think should be consistent with another 50bp hike at the August Bank of England meeting. This is not yet fully priced in, so we see room for continued sterling strength.
The disinflationary news in the US sent the euro straight higher, and the common currency broke cleanly out of the range that had held for most of 2023, soaring above to its strongest positions since February 2022. The move is understandable given expectations for a narrowing in US-Euro Area rate differentials and in line with our forecasts, but gloom around European growth may provide some headwinds in the short-term. The Euro Area economy is currently in the midst of a recession, and recent soft economic indicator data suggests that another quarterly contraction in GDP could be on the way in the third quarter. Until the state of the Eurozone economy is clarified and the pessimistic PMI numbers are confirmed or refuted by hard economic data, the euro may have a difficult time rallying any more in the near-term, particularly given stretched market positioning. Major data out of the common bloc is scarce this week, aside from revised inflation data on Wednesday.
The June inflation report confirmed that US inflation is slowly but clearly headed the right direction. Inflation undershot expectations in both the headline (3.0%) and core indices (4.8%), and the three-month running average in the latter is now down to 4% on an annualised basis – this metric has only been lowering on one occasion since the start of the current inflationary episode (September 2021). The Fed is still likely to hike rates again in July, having effectively pre-committed to do so. However, any further hikes would need significant upside surprises in inflation data and economic activity, which we see as unlikely. Markets appear to be in agreement, with futures now assigning only around a one-in-four chance of a second hike before November. With the Fed hiking cycle seemingly coming to a close, the backdrop turns more favourable for our core view that emerging market currencies have further to appreciate.