Financial markets were becoming increasingly comfortable with the idea that the worldwide hiking cycle was over and were beginning to look forward to rate cuts, until Fed chair Powell sounded less convinced at a speech last week. In response, bond rates increased again and currencies partially reversed recent moves, as the dollar rallied against almost every major currency. The big underperformers were the Australian and New Zealand dollars, which struggled amid the general risk off mode and concerns over the state of the Chinese economy, after Asia’s largest economy fell back into deflation. Sterling also ended the week near the bottom of the FX performance tracker, despite a beat in the latest UK GDP report. Uncharacteristically, stock prices generally held up well, in a sign that market conviction for more rate hikes was not high.
The monthly US CPI inflation report has become the most critical piece of economic data worldwide, and Tuesday data for October is, if anything, even more critical in light of Powell’s hawkishness. Markets are pricing in a core monthly number in line with a 3-4% annualised inflation rate, but any positive or negative surprise will have an outsized impact in currency markets. The UK will see an unusually data intense week with the labour report out on Tuesday and October inflation released on Wednesday. An important, albeit lagged, September reading on Eurozone industrial production on Wednesday will round out the trading week.
Third-quarter GDP figures released last week confirmed that the UK continues to avoid a recession, but only just. The economy stalled last quarter, posting flat growth in the three months to September, but at least avoided the contraction that had been market consensus. The monthly numbers were slightly more positive, and we remain confident that the UK economy will be able to eke out modest growth in the last quarter of the year. Labour data and inflation out this week are key. Markets are expecting another significant fall in core inflation, to a still high 5.8%. As with the dollar, sterling can be expected to react quite strongly to a surprise in either direction, as this remains key for Bank of England monetary policy. MPC members Bailey and Pill largely reiterated recent communications last week, stressing that interest rate cuts remain a long way off.
Last week was a quiet one in the Eurozone, with little news of note either on the economic or the policy front. News that we did receive was largely bearish for the common currency so the relative resilience shown in the euro, which outperformed most of its major peers, is notable. Both retail sales out of the Euro Area and German industrial production contracted more-than-expected in September, while the revised composite PMI remained well below the level of 50. This has done nothing to ease concerns over the possibility of a recession in the bloc, which remains a real possibility in the second half of the year.
Markets are pricing in almost a full ECB interest rate cut by April of next year, although policymakers continue to push back against this narrative. Lagged data points continue to point to a stagflation environment, which will make it very difficult to cut rates in the Eurozone any time soon, in our view. Data on Euro Area GDP (Tuesday) and October inflation (Friday) will be very closely watched this week.
With little macroeconomic news of note last week, Powell´s perceived hawkishness grabbed traders’ attention and drove market action in currency markets. Inflation data this week will be a key test for the deflationary narrative that expects Federal Reserve cuts as early as the second quarter of next year, a notion against which most Fed officials themselves are pushing back. In addition to the inflation report, we will be closely following the fallout from the news that Moody’s has cut the outlook for US debt to ‘negative’, on general deficit and governance concerns. These downgrades have usually had very little impact in the past, although this news comes at a time when the US Federal interest bill will top one trillion dollars, with no end in sight or prospects for fiscal tightening.