United Kingdom: Bank of England have no easy choices ahead
What we saw last week from the Bank of England (BoE) indicated an unease about the set of macroeconomic circumstances and the outlook presented before them. The Monetary Policy Committee voted 6-3 in favour of a 25 basis point rate increase, the 3 dissenting votes favouring a 50 basis point rate increase instead. However, the statement accompanying the decision was not as hawkish as the financial markets initially interpreted. In particular, the language where the BoE stated they would act more aggressively if inflation conditions warranted it, was seen as a warning of the risks of faster rate hikes, but I am not so convinced. Furthermore, comments made on Friday by BoE Chief Economist, Huw Pill, suggested he, at least, wanted to row back from the narrative of more aggressive hikes to come. He stated that the particular commentary was to update the guidance from the Bank of England, and actually could be interpreted either way, in terms of monetary tightening or loosening, dependent on prevailing economic conditions.
It appears increasingly clear that the outlook for the UK economy has deteriorated, and that could mean that further interest rate hikes would be viewed as doing more harm than good. There are certainly no easy choices when it comes to monetary policy, and the UK economy could end up in recession even without any further monetary tightening from here on. The markets on the other hand have continued to build in greater and greater amounts of rate increases, equity values have continued to slide, and GBP has remained volatile, but the risks continue to lie to the downside versus both the USD and EUR, in my view. The sharp increase in interest rate hike expectations is perhaps best outlined by the change in the Bloomberg World Interest Rate Probabilities, which has seen the market price in an additional 1 percentage point in tightening since mid-May, suggesting that UK interest rates would be above 3% by the end of 2022.
Highlighting the deterioration in UK economic conditions, last week saw the monthly Gross Domestic Product (GDP) data for April record a surprise 0.3% month-on-month drop in economic output, and whilst the UK labour market figures for April and May were marginally better than expected overall, there remains a nagging doubt that such moves are sustainable.
This week’s key releases are May consumer price inflation on Wednesday, provisional June Chartered Institute of Purchasing and Supply (CIPS) manufacturing and services Purchasing Managers Indices (PMIs) on Thursday, and then June Growth from Knowledge (GfK) consumer confidence and May retail sales on Friday. Could the figures and surveys point to a further deterioration in the economic outlook and is it a forgone conclusion that the headline inflation rate will continue to rise? The GfK consumer confidence reading remains of greatest interest to me, in terms of whether there will be a new record low, and just how much worse the components, such as the personal finances and major purchases indices can get?
I continue to believe that the UK is at greatest risk of a recession versus the other economies, and that may also mean that the GBP is disproportionately disadvantaged. However, it is almost incomprehensible to me that the Bank of England would raise interest rates to anywhere close to what the UK financial markets currently have priced in.
United States: Fed meets ‘clear and present danger’ from inflation with 75 basis point hike
The last time the Federal Reserve raised interest rates by 75 basis points was December 1994. That year saw Harrison Ford star in the Tom Clancy based movie ‘Clear and Present Danger’, one of more than 20 blockbuster movies released that year. The Fed certainly appear to believe that the predicted path of inflation over the coming years presents them with a real and lasting threat, and seemingly plan for more significant tightening in the coming meetings. The 75 basis point hike was interesting in that it wasn’t really being priced for until very close to the meeting itself, when an article in the Wall Street Journal appeared on Monday, and then several large American banks changed their call. What was also interesting was that Jerome Powell had himself downplayed the prospect of such a tightening only weeks before. So something has materially changed at the Federal Reserve to bring about such a large tightening, and threaten the prospect of another 75 basis point hike in July.
The latest dot plots were also telling, suggesting that US interest rates would end 2022 at 3.5% according to the consensus of Fed members, although that is still slightly shy of market consensus forecasts, which have the upper target bound at 3.68%. I can only imagine what damage such hikes will inflict on the US economy, which showed signs of frailty last week, with a slump in US housing starts in May, a surprise drop in retail sales values in May, and weakness in the Empire manufacturing and Philly Fed business outlook indices for June.
The markets will be interested in this week’s releases of May existing and new home sales that top and tail the week, and in between those more data on weekly mortgage applications, latest weekly jobless claims, provisional June manufacturing and services PMIs and then final June University of Michigan consumer sentiment figures. The risks are that the weight of evidence points to a worsening in macroeconomic conditions, but is that enough to lower interest rate expectations?
The USD was volatile last week, but strengthened to a fresh multi-decade high of 105.788 on a dollar index basis, whilst USDJPY rose to the highest it has been since December 1998. Can it push to fresh highs this week? I think that has to be the risk. Neither the Bank of England nor European Central Bank look as comfortable raising interest rates as the Federal Reserve appear to be, and that could continue to provide support to the USD for the foreseeable future, even in the face of worsening economic data.
Europe: European Central Bank’s emergency call offers little clarity
Last week saw the European Central Bank (ECB) call an emergency virtual meeting. We assumed that was to discuss both the rise in bond yields, which at times seemed to take on a life of its own, and also heightened inflation expectations. The markets immediately assumed the ECB would outline a plan to deal with excessive bond market volatility and also possibly hike interest rates, or perhaps signal a larger hike was more likely in July. What they got instead was the ECB committing to forming a panel to look into what needs to be done to stabilise bond markets, and not much else.
In the meantime the data and survey releases, which were fairly light, centred around the German ZEW* survey for June. That reported another improvement in the current situation index as well as in expectations, albeit expectations bounced less than had been expected. The euro wasn’t really watching the economic data and was too distracted by the emergency meeting, which wasn’t as much of an emergency after all.
For the week ahead, the provisional June Euroland manufacturing and services PMI indices and the German IFO** business climate index are the key releases in focus. Could these contradict one another, with the IFO index improving whilst the PMIs worsen? I think that is the risk, which would be confusing for the ECB and also the markets.
If the outlook for economic activity worsens, then the EUR is likely to come under pressure, albeit that the EUR appears to be being supported better as risk appetite deteriorates than other currencies, such as the GBP. Is this a significant shift in terms of investor sentiment, driven by European interest rates that might be on the cusp of turning positive, or at least no longer being negative? Perhaps the ECB will follow in the Swiss National Bank’s footsteps and do more than the market is anticipating come July?
* Zentrum für Europäische Wirtschaftsforschung, Germany’s Sentiment Index
** Information and Forschung (research)
Central banks: Singapore National Bank surprise with a hike; tightening to continue this week
Last week saw the Swiss National Bank (SNB) meet amidst what were billed to be more important meetings from the Federal Reserve and the Bank of England. However, it was the SNB that surprised the markets the most, choosing to raise interest rates by 50 basis points, taking the policy rate to -0.25%, the highest it has been in 13 years. The rise was in direct response to rising inflation risks, and led to a sharp appreciation of the Swiss franc, something that the SNB had previously been actively trying to guard against. Also last week, there was a 50 basis hike in the Brazilian Selic rate to 13.25%, taking Brazilian interest rates to the highest level they have been since December 2016. There are still further hikes likely to come in Brazil, but the pace of hikes appears to be slowing, such that Brazilian interest rates should peak before the end of 2022, in my view. The Taiwanese central bank also raised interest rates last week, but by a less than expected 12.5 basis points.
This week, the People’s Bank of China have already met and agreed to leave interest rates on hold, pausing the easing cycle they have recently embarked upon. In the remainder of the week, the Czech Republic central bank are set to hike by between 1 and 1.25 percentage points, the central bank of the Philippines are set to hike by 25 basis points, the Bank of Indonesia should leave interest rates on hold, the Norges Bank hike to 1% from 0.75% and finally Banxico should hike a further 75 basis points, in my view. The rate hikes are driven by a combination of inflation and FX market concerns, and there are still risks that some central banks do more than is currently priced in by the Bloomberg consensus, in my view. What is less clear is whether such monetary tightening will have the desired effect in terms of supporting currencies or repelling medium term inflation pressures.