Hawkish Fed communications, which suggested that the FOMC could hike further and is in no hurry to cut rates, sent interest rates worldwide higher yet again. The key US 10-year Treasury rate led the way, breaking to fresh multi-decade highs. Risk assets worldwide tumbled, stocks and commodities fell, and credit spreads widened. The impact on currency markets was mixed. The dollar rallied for the most part, but traditional safe havens like the Swiss franc and the Japanese yen stumbled on dovish surprises from their respective central banks. Sterling also underperformed, after the Bank of England unexpectedly voted in favour of keeping interest rates unchanged, after a surprise miss in the August UK inflation report.
With the major central bank meetings in September out of the way, attention now shifts to economic data. Policy making has become more uncertain and unpredictable than it has been since 2021. Central banks are hoping that current rate levels are sufficient to put inflation on a sustained downward trajectory. Incoming inflation data is, therefore, now more important than ever. The flash September CPI report for the Eurozone is the most critical data point of the week, followed by the August PCE inflation report out of the US. Both are scheduled to be published on Friday.
The Bank of England took advantage of the positive news on inflation we received earlier in the week to hold rates unchanged, albeit in a very tight vote of five to four. The MPC kept the door alive to additional policy tightening, although there is now a general sense that the bank is looking to wrap up the hiking cycle. Interest rate pricing after the meeting suggests as much, with swaps now seeing less than a 50/50 chance of a final 25bp hike by year-end.
The pound reacted negatively to this dovishness, ending the week down over 1% against the dollar and coming in dead last among G10 currencies. Sterling’s performance is clearly tied to expectations for rate hikes in the UK, and these in turn will depend on future inflation data. Policymakers also voiced heightened concerns over the UK growth outlook, while downgrading their Q3 GDP assessment to near flat growth. Revised data on second quarter growth will be released on Thursday, although we would expect sterling to trade largely off developments elsewhere, given the significant time lag in the data.
The euro lost ground against the US dollar last week, yet again, but at least the pace of the decline is slowing, and the common currency may have found a bottom. The contrast between the buoyant US economy and the stalling European one, and pessimism on China’s economic recovery, are serious headwinds for the common currency. However, we think that current currency levels are already pricing in a pretty gloomy scenario, and Chinese economic data is starting to surprise to the upside.
This week’s flash CPI report will be key for the euro. Markets are expecting a significant drop in both the headline and core prints. Any disappointment on this front would probably fuel a strong euro rally, as expectations for further hikes are priced in. ECB President Lagarde will be speaking before the inflation data on Monday, although she is unlikely to add anything new from the last Governing Council meeting.
The Federal Reserve refrained from raising interest rates last week, as was universally expected, although it made up for this by revising sharply upward its expectations of future interest rate levels in the “dot plot”. The median dot for 2023 was unchanged relative to the June projections and continued to pencil in one more rate hike this year, while the forecasts for 2024 and 2025 were both shifted up by 0.5 percentage points. This sends a clear message to markets that inflation is far from beaten, especially given the strength of the US economy, and that rates will need to remain high for longer than previously anticipated.
The consumer inflation reports earlier in the month provided a hint that inflation is not completely contained. This Friday’s PCE inflation report, the Fed’s preferred gauge, will be highly important. Markets are expecting another subdued number, which should allay concerns about further Fed hikes and perhaps cap the dollar rally for the time being.