Post date: 21/06/2021 12:36
The Federal Reserve administered a serious corrective to general financial market ebullience last week. The ‘dot plot’ suggested that most members expect hikes to come no later than the end of 2023, from mid-2024 in the previous projections. Short-term rates in the US shot up higher and the dollar rallied, as markets priced in a Fed that will not be as tolerant of inflation as they had expected. For now, markets are reacting exactly as one would expect after a significant hawkish surprise. Real rates are rising, inflation expectations dropping, risk assets are selling off and the US dollar is unambiguously king. Only the Brazilian real among major currencies managed to outperform the greenback last week.
The focus this week will be squarely on a veritable storm of speeches and communications from Federal Reserve officials, nearly a dozen of them spread throughout the week. Markets will try to elucidate the extent and conditions of the Fed's hawkish turn. On the macroeconomic front, the Eurozone and UK PMI indices of business activity will be released, but we think expectations for a very strong number will be validated so the market impact should be limited. Finally, the Bank of England June meeting is on Thursday.
The UK saw another spate of positive economic news. Unemployment fell sharply in May, while wage growth sped up. Inflation continued the recent trend worldwide, surprising to the upside. None of this mattered much as markets were upended by Federal Reserve hawkishness. The Bank of England meeting this week takes on added interest on the back of this hawkishness. We think it's possible that the MPC will follow in the Fed's footsteps, at least rhetorically, by signalling that it may be in a position to wind down its asset purchase programme sooner than originally anticipated. We expect sterling to be well supported as a result, especially against the euro.
A solid monthly gain in May industrial production out of the Eurozone was completely overshadowed by the Fed meeting. The dollar rally was exacerbated in the case of the euro by the clearing out of the long positions traders had accumulated going into the Fed meeting. This week's flash PMI indices of business activities should remain extremely high, as activity soars on the back of the lifting of lockdowns, but their market impact should be limited as markets will be focused on comments and speeches from Fed officials.
A softer turn in second-tier economic indicators out of the US was roundly ignored by markets after the hawkish surprise delivered by the Fed last week. In addition to the ‘dot plot’ suggestion that the Fed is bringing forward its calendar for hikes. Chair Powell's press conference suggested that the Fed has much less tolerance for above target inflation than previous communications had led markets to assume. More generally, the Federal Reserve seems to share our views that the main short- and medium-term constraints to US growth are in the supply side, not the demand side. We wait for the plethora of Fed speeches this week to clarify this shift in outlook, but some revision to our forecasts may be forthcoming in the next two weeks.