In turn that prompted a reduction in risk appetite, which saw bond yields fall, equity markets lose ground having attempted a rally from the previous week’s lows, and the GBP and EUR sell off against the US dollar. There was also a significant further adjustment to UK interest rate expectations, with the markets at one point removing one further rate increase from the UK hiking cycle, but re-pricing for it by the end of the week.
United Kingdom: GBP vulnerable to risk appetite collapse
What the moves of the last week demonstrated was an asymmetry of risk for the UK, where growth, interest rates and equity markets are all likely to be put under pressure to the downside in the coming months and quarters. The situation in Eastern Europe has pushed oil and gas prices higher (oil prices to the highest since 2008, gas prices are now at all-time highs), create further problems for supply chains, and worsen liquidity across all financial instruments and markets, which in turn is likely to increase volatility.
The economic narrative therefore is likely to be far less important for the direction that FX markets will take, and this week’s data and survey release calendar from the UK is pretty light in any case. There will be interest in the raft of January activity data released on Friday, but from the perspective of where the UK economy was prior to the outbreak of war on the European continent.
In terms of FX markets, the risks to the GBP are that the sell-off against the USD accelerates, whilst against the EUR we could see GBP suddenly run out of momentum and start to push lower, if the financial markets see fit to price-out UK interest rate hike expectations again. That has to be the risk in my book, with a combination of weaker growth and stronger short-term inflation pressures an unappetising mix for the GBP. If GBP breaks beneath the $1.3175, then the next move, could be fairly quick and brutal, with GBP testing through $1.30 and towards $1.27, in my view. As for GBP/EUR, the multi-year high, reached last week at €1.2150 could offer renewed resistance this week, and beyond a test of €1.22 is likely to meet stiff resistance also, in my opinion.
United States: US Fed to choose gradualism over ‘shock and awe’; Consumer Price Index in focus this week
What the US monetary authority hinted at last week was a gradual tightening in monetary policy to try and prevent more serious second-round effects from the cost-push inflation seen recently. Comments from Federal Reserve Chair, Jerome Powell, to the House Financial Services Committee and then the Senate Bank Committee, indicated that Powell favoured raising interest rates gradually, so in 25 basis point increments rather than more aggressively. That said, Powell recognised that there were risks on both sides, with inflation overshooting by more than was expected and growth at risk of being much slower thanks to the spike in energy prices prompted by the invasion of Ukraine by Russia. Gradualism is, in my view the right approach, although I don’t rule out a larger hike entirely, given the concerns amongst some members of the Federal Open Market Committee, and comments in the Beige Book about ‘brisk’ price increases in stores.
Last week’s attention was on the US labour market data for February. This recorded a strong bump to non-farm payrolls, which grew by a net 678,000 in February, after a 481,000 rise in January. The unemployment rate dropped to 3.8% from 4%, edging ever closer to the all-time low of 3.5% recorded in 2019. However, average earnings growth fell back in February from 5.5% to 5.1% year-on-year, suggesting that the growth of wages was not as problematic as may have been feared, albeit we should not read too much into one month’s data, which could be revised.
Downside risks to economic activity from the invasion of Ukraine will, in my view, dominate over data releases this week, albeit that the consumer price inflation data for February, and provisional March consumer sentiment data from the University of Michigan, were likely to contradict one another anyway. The risks are for a further surge in inflation but an additional collapse in consumer confidence. How long before we see the cost-of-living issues undermine home buying, the purchase of motor vehicles and other discretionary purchases?
As for the USD, I think it will continue to be well supported against the EUR and GBP, with a flight to quality and lower liquidity levels supporting an additional rally in the dollar over the course of this week. Sanctions and the conflict are likely to escalate further, before things begin to get better.
Europe: Risks to the downside for growth and the euro
Europe has been closer to the pointed end of the deterioration in geopolitical relations between Russia and Ukraine, with its economy far more dependent on Russian oil and gas than others. Last week’s data and surveys reported a further increase in inflation rates in February from a number of major countries, as well as Euroland aggregate, whilst the manufacturing and services Purchasing Managers’ Indices slipped in final readings for February, versus the initial ones. Already this week we’ve seen a collapse in the Sentix investor confidence index for March, which fell to its lowest reading since November 2020 on fears over the invasion.
Last week also saw comments from European Central Bank (ECB)Governing Council members Rehn and Holzmann, both of whom have been swift to row back on any suggestions of the need for monetary tightening as this new threat to activity and stability emerges. It is interesting that the European Central Bank have, in my opinion, had a better interpretation of what’s been going on in the global economy all along. They were reluctant to join in with sounding the all clear on the economy, as the Federal Reserve and Bank of England were doing, and have also been far more concerned by events in Europe than the UK and US central banks.
This week’s data and surveys aren’t likely to provide much by way of signals for the direction of travel for the macro economy or the euro. Indeed, if the situation in Ukraine continues to deteriorate, with the Putin regime having issued a direct warning to Romania about Ukraine using its airfields, then the short-term risks remain to the downside for economic activity and the EUR against the USD and GBP. What happens in the medium term is more uncertain, and I think that other central banks will have to make wholesale changes to their forecasts for interest rates versus the European Central Bank. That could still offer the EUR some medium-term support, or it might at least mean it finds its base more quickly!
The ECB meeting this week is likely to see ECB President, Christine Lagarde, indicate some of these wholesale changes to the central bank’s thinking as far as growth and interest rates are concerned. Her ongoing calm stewardship could yet be the source of EUR strength in the medium term, in my opinion.
Central Banks: Russia hikes unexpectedly; lasting inflation damage and geopolitical risks pose problems for central banks
Last week saw the RUB depreciate to fresh lows and over the weekend the RUB has been further damaged. The sell-off in the currency and risks to financial stability in Russia prompted a massive interest rate increase by the central bank of Russia, taking official rates to 20% from 9.5% – surpassing levels seen in the grip of Russia’s annexing of Crimea back in 2014. The risks to the RUB are for further weakness, with a real threat that it could depreciate well beyond RUB170 to the US dollar in the coming days or weeks as the crisis intensifies and sanctions increase.
Last week saw the Reserve Bank of Australia and National Bank of Malaysia hold interest rates unchanged, but the Bank of Canada raised interest rates to 0.5% from 0.25% as it began to seek normality in policy. I would argue that central banks will have to look beyond the current supply-side-driven inflation increases to the far more damaging hit to net disposable income and consumer confidence that I see coming down the round.
This week’s central bank meetings begin with the National Bank of Poland, which is expected to hike another 50 basis points to take interest rates to 3.25%; the central bank of Peru, which is expected to hike to 4% from 3.5%; and the central bank of Kazakhstan, who may have to implement a significant hike in monetary policy as the Tenge has taken a battering in FX markets lately.