Post the European Central Bank and Fed decisions, attention switches to the Bank of England

Last week’s central bank meetings from the US and Euroland left markets in a state of confusion. The Federal Reserve left interest rates on hold, but warned of further tightening to come, while the ECB (European Central Bank) hiked by 25 basis-points, but also argued it will do more in the meetings to come. The questions that emanated post these decisions were obvious ones. If the economy is likely to need higher interest rates in the future to cool inflation, then why didn’t the central bank hike now? Also, why does a seemingly deteriorating economic picture have little or no impact on the outlook for inflation? 

The BoE (Bank of England) now takes centre stage this week, with the markets expecting a 25 basis-point rate increase, and that’s despite some speculation on the newswires that the Monetary Policy Committee could be tempted to hike by 50 basis-points instead. Such a move looks unlikely in my view. The BoE has commissioned a review into its inflation forecasting, after criticism from politicians and the media about the poor performance of the BoE in predicting the surge in inflation, or its longevity. Is there additional risk for an elongated overshoot of inflation versus target, and what would that mean for the potential peak in interest rates? Is there a growing threat to consumer spending from higher mortgage borrowing, car financing and unsecured personal loan rates? 

Preceding the BoE meeting are the releases of consumer, retail and producer price inflation figures for May, and post the meeting, the May retail sales report. The inflation picture might be mixed, with consumer price inflation still sticky at a core level, but falls in producer price inflation rates pointing to weakness ahead. As for the retail sales data, will the three bank holidays in May, and the King’s Coronation have prompted an increase in sales volumes? I think it likely, but I would expect June to be adversely affected subsequently, despite the warm weather. 

GBP continues its rally, but how much further is there to go?

GBPUSD hit a 14-month high last week at $1.2848 and GBPEUR had a series of looks above €1.17, before seemingly settling above that level at the end of the week. Is there much further for GBP to go in terms of a move higher? Particularly given that the rally in the pound has been driven predominantly by the rise in UK interest rate expectations, with markets predicting a peak in the UK Bank rate of over 5.75%, further GBP rallies may prove harder to sustain. While there has been some increase in the US and Euroland interest rate peaks, the move in the UK has been disproportionately large. 

I am not convinced that there is that much further upside for the GBP based on interest rate hike expectations in the UK. Should UK interest rates peak close to 6%, the consequences on the UK economy are likely to be significant (in terms of a negative impact on discretionary spending and also fixed investment spending). I also think that interest rates won’t peak at that level but more likely between 50-57 basis-points below there. What happens to the pound if UK interest rate expectations reduce disproportionately to those in the US and Euroland? What happens if the UK economy starts to feel the effects of weaker global activity on order volumes and investment, as we have seen in parts of the US and Euroland economies? 

Are the risks for European central banks to the topside this week?

Aside from the BoE meeting this week, there are central bank meetings from the SNB (Swiss National Bank) and the Norges Bank in Europe. Both the SNB and Norges Bank are expected to raise interest rates by 50 basis-points, although the markets are less convinced than we are about both these outturns. With the European Central Bank delivering a hawkish 25 basis-points, and the Federal Reserve talking about hikes later in the quarter, the risks have to be for larger hikes from both of these central banks. 

As for the other central banks this week, it is unlikely that we get much from the central banks of Chile, Brazil, Indonesia, Philippines or Mexico. Indeed, in many of these economies the next move in interest rates is expected to be down. 

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