Federal Reserve and European Central Bank meetings in focus this week

The Federal Reserve and the European Central Bank meet this week amidst further signs of trouble in both economies, and some additional constructive behaviour in terms of inflation expectations having been seen.

The markets are still convinced that the Fed will not hike interest rates on Wednesday. There are concerns over the weakness of the US economy, and signs of further reductions in inflation now joined by the first signs of sustained labour market weakness, according to unemployment and underemployment data in the May labour market report.

Ahead of the Federal Reserve’s decision, we get the May US consumer price inflation figures released on Tuesday. Headline and core CPI (Consumer Price Index) inflation are expected to fall again in this latest reading, to 4.1% and 5.2% respectively, from 4.9% and 5.5% year-on-year in the April readings. If that happens, then there would be no reason for the markets to expect anything different in terms of the Fed decision, but it could lower expectations of any further tightening from the Fed. Markets might even increase the expected risk of a loosening in monetary policy before the end of the year. If inflation rates don’t drop by as much as expected, the Fed might still continue to pause in its tightening schedule, but the timing of any cuts could be pushed further out. 

As for the ECB (European Central Bank), the markets still price in virtually a 100% chance of a 25-basis point hike in all the Euro Area interest rates. That’s despite more evidence of weakening economic activity (April industrial production figures, downward revisions to German and Euroland Q1 growth which puts both into a recession etc), and signs of weakening inflation expectations also.

Could the ECB Governing Council signal that the peak in Euroland interest rates is closer than imagined? The financial markets have already reduced the number of rate increases priced in, with the peak in the refinancing rate expected to be 4.25% or lower. That, combined with the weakening in data and inflation has left the euro under pressure against the likes of the GBP, and struggling for momentum against the USD as well.

This week also sees some notable Euroland data releases, including the German ZEW* survey for June, Euroland industrial production for April, and the final May consumer price inflation figures for most major countries and the Euro aggregate. 

*Zentrum für Europäische Wirtschaftsforschung / Germany’s Sentiment Index

USD losses at the end of last week to continue?

The USD appeared on the defensive into the end of last week. The risks on the US economy appear to be to the downside, and there is a high probability that the Federal Reserve will go a different way to the other major central banks. These risks could prompt a renewed fall in the USD, with GBPUSD and EURUSD testing recent highs around $1.2670 and $1.0830 respectively. That said, the US central bank is perhaps realising that the downside risks of a credit squeeze and signs of stress in the US labour markets could prompt an undershoot of inflation versus target. 

I think the USD will struggle against a negative economic backdrop. The other currencies don’t exactly have a positive outlook either, but there is still likely to be a closing of interest rate differentials that offers the GBP and EUR relative support versus the USD. The dollar isn’t losing ground everywhere, and continues to make headway against the likes of the Chinese renminbi and hold onto gains versus the Malaysian ringgit and Japanese yen. So even if the USD loses more ground to other major currencies, it could benefit from additional gains against emerging currencies, in my view. 

After the surprises from the Reserve Bank of Australia and Bank of Canada will there be a surprise from the Bank of Japan?

The RBA (Reserve Bank of Australia) and BoC (Bank of Canada) both surprised the markets by hiking interest rates 25 basis points last week. Ongoing concerns over the pace of returning inflation to target and the effect that might have on inflation expectations drove those moves, and asked questions about what other central banks might do.

The only significant central bank meeting of this week is the BoJ (Bank of Japan). It has so far been happy to sit on the sidelines, making fewer adjustments to monetary policy than other central banks, even while inflation has increased well beyond target. Would the BoJ be willing to raise conventional monetary policy?

The chances are not zero, but even after a stronger-than-expected outturn for Q1 GDP (Gross Domestic Product), the risks are minor that there will be any additional BoJ moves at this meeting, conventional or otherwise, in my view. The weakness of the yen does offer further reason to anticipate a policy change from the BoJ at some point, but that point is several meetings in the future, in all likelihood. 

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