Weekly Market Update

Fed set for hawkish hold as Iran military attacks resume

Tonight’s FOMC rate decision brings with it a level of intrigue and uncertainty that we’ve perhaps not seen for a number of months.

Highlights:

The general consensus among market participants and economists, ourselves included, is that the Fed will keep rates unchanged later today, though futures see a non-negligible possibility (around one in three) of an immediate hike. It is actually quite rare to be heading into a Fed meeting with markets attaching such high odds to the surprise outcome, which makes today’s announcement all the more intriguing. Logic dictates that a decision to hike would provide a big boost to the dollar, while a hold would trigger some downside. While we certainly agree with the former, losses for the greenback until the latter could be kept in check should the Fed strongly hint to markets that a rate increase at the next meeting is in the offing.

Meanwhile, military attacks resumed between the US and Iran overnight following a brief hiatus in hostilities. This is creating a challenging backdrop for central bankers across the board, as they attempt to react to both the data in hand and the prospect of a fresh spike in energy prices, and therefore inflation, down the line. The Bank of England also appears set to hold on Thursday, with the Bank of Japan to follow suit on Friday. The latter could be particularly interesting as we think that we’ll probably need to see a pretty hawkish set to communications from the BoJ to prevent another fresh bout of selling in the yen.

USD

All eyes today will be on this evening’s FOMC announcement. The reescalation in the war in Iran is making for an increasingly challenging backdrop for central bank officials, and the Fed is no exception. While there have been some suggestions that the Fed may raise rates today, we instead favour a hawkish hold. The pausing of military strikes over the weekend has brought some relief to oil prices, while we remain of the view that there is nothing really in the data that would warrant a more hawkish approach. Recent inflation reports have come in soft, while the labour markets is in a “goldilocks” state that provides no real urgency to hike. We instead expect the Fed to rely on familiar phrases about “elevated uncertainty” and a data dependent approach. This would provide the bank with maximum flexibility to hike at future meetings, without needing to explicitly say as much.

Markets are eyeing a rate increase at the next meeting in September, so the communications would need to be hawkish to prevent a drift lower in the dollar, and we think that the Fed will oblige. Wording along the lines of the FOMC being “vigilant to upside risks to inflation” would signal intent without cementing expectations for hikes ahead. We neglected to mention in our FOMC preview the possibility that a handful of the hawks could also dissent in support of an immediate hike, which could also prop up the dollar in the event of no change. Yet with a September hike fully priced in, we think that the bar for a hawkish surprise is high, and to move the needle Warsh may need to firmly signal that a hike is coming, which we don’t think is likely given his aversion to forward guidance. This could open up some downside in the greenback in the second half of the week.

EUR

The resumption in military strikes between the US and Iran overnight has dampened sentiment in markets somewhat, though the euro continues to receive some support on the dollar. Peace appears to remain the central scenario for market participants, with the pausing in strikes earlier in the week providing hope that negotiations will soon resume. While the prospect of an easing in the geopolitical risk, and drop in oil prices, could provide some upside potential for the euro, we would expect this to be capped by any downward repricing in ECB rate hike expectations, which we continue to contend are overly aggressive.

This week has been quiet on the data front, though investors will be closely watching tomorrow’s preliminary estimate of second quarter GDP growth in the Euro Area. Economists are bracing for a modest rebound in activity following the disappointing Q1 print, though other advanced indicators, including the recent business activity PMI figures, suggest that the data will likely remain consistent with an economy in stagnation.

GBP

Politics looks set to take a back seat today as the Bank of England will be meeting for the first time since prime minister Burnham walked through the doors of Number 10. On the surface, the renewed hostilities in the Middle East give real ammunition to the hawkish faction of the MPC. Yet we think that neither current oil prices nor recent economic data warrant a hasty response, either in the form of an immediate rate hike or an overly hawkish set of communications. Headline inflation has undershot the bank’s expectations for three months running, wage pressures are softening and the labour market continues to shed jobs, rather than add them, which means that the MPC may see inflation peaking at closer to 3% than 4%.

That’s not to say the MPC won’t strike a hawkish note on Thursday. On balance, we think the vote will land at 7-2, as it was in June, though a wider 6-3 split cannot be entirely ruled out should Lombardelli join Pill and Greene in voting for a hike. Governor Bailey, meanwhile, will likely stress that the bank is continuing to monitor the situation in the Middle East and stands ready to act if required. He’s unlikely, however, to lean too heavily into hawkish language for fear of over-inflating market pricing for hikes, while the updated forecasts could even deliver a modest downgrade to the inflation view. We do not think that the MPC will be in a rush to raise rates and believe that risks to the pound are skewed to the downside going into this week’s meeting.

Economic Calendar

Wednesday 29/07

Thursday (30/07)

Friday (31/07)