Economy beginning to slow before rate hike and Omicron

Data released yesterday showed that even before the level of infections from the new variant of Covid-19 arrived, the economy was facing difficulties in maintaining the level of growth seen in Q2.

Quarter on quarter growth in Q3 was 1.1%, versus a previous estimate of 1.3%. Year-on-year, the economy grew by 6.8%, up from 6.6%, but with quarter on quarter growth slowing, this is unlikely to improve in the fourth quarter.

City centres are seeing less activity in the run-up to Christmas than is usually seen. The so-called lockdown by stealth is having a significant effect on activity.

Questions may well be raised about just how strong the recovery will be and when GDP will reach pre-Covid levels.

There has been criticism of the Government’s blanket one off payment of £6k to hospitality businesses with small independent outlets suffering far more than chains who are able to ride out the storm far more easily.

The Chancellor is likely to be more circumspect about relief and support than he was during the first two lockdowns since he, along with most of Parliament, is unsure about how virulent the Omicron variant really is.

Reports suggest that while Omicron is spreading faster than the Delta variant did, it is around40% less likely to cause serious illness. While this is reason to be relieved, the sheer scale of infections could mean that the NHS could still be overwhelmed.

As if to confirm the virulence of the new strain, the UK registered over 100k new infections yesterday, for the first time since the Pandemic arrived in the country.

Financial markets are seeing a divergence of opinion over the future path for Sterling. Convincing arguments are being put forward that predict that the pound will continue to fall versus an all-conquering dollar while others believe a recovery to around the 1.35 level is possible.

For now and for the first few weeks of the new Year, it is most likely that Sterling will trade in a narrow range until a pattern emerges, Omicron is brought under control and inflation and activity data for December are released.

It all appeared like plans sailing when the Bank of England tightened monetary policy by raising interest rates last week, but uncertainties have returned and investors are unsure.

Yesterday, the pound rallied to its highest level in a month against the dollar. It reached a high of 1.3363 and closed at 1.3362.

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FOMC facing difficulties from growth and inflation

Remember the time before inflation returned and the main driver of the currency markets was risk? Well short of any new factors to drive the dollar, risk appetite has returned to provide a degree of volatility to the dollar in the final week of the year.

The expectation is that as risk appetite grows, the dollar, as the global medium of exchange, weakens as investors begin to look at expanding their portfolios.

Currencies that are considered riskier, like the pound and euro, perform better despite the concerns of their underlying economic strength. Furthermore, traders want to trade, so they will latch onto anything that provides them with the means to make money.

One further reason for the apparent disarray in the U.S. market is the uncertainty that has been created by the debate around President Biden’s build back better plans.

It seems that several Democrats see the plan as unnecessary, with the President almost interfering in order to take some credit for the nascent economic recovery.

The Fed is making the right noises and now, the trite moves to cope with its mandate of creating stable growth while ensuring that the employment rate comes close to full employment.

While it is more within the purview of Biden’s predecessor to take credit for someone else’s achievements, the President will need to ensure that he retains the support of congress for battles that still need to be fought.

The Fed has given markets a very clear signal that the era of easy money is coming to a close. Washington has the Central Bank in its sights, as inflation is expected to be its main focus.

In Political circles, it had been assumed that the beast of inflation had been slain, but it now seems it was only sleeping, awaiting conditions to be right for it to return.

A few months ago, there were questions about whether the FOMC would need to hike rates at all in 2022. Now, many analysts are expecting two hikes in the first half of the year, as the rate at which support is being withdrawn has been doubled.

The dollar appears to be running out of steam, unable to make inroads into resistance around the 96.60 level.

In time-honoured tradition, once that zenith has been reached, the time has arrived to try the bottom of the range.

Yesterday, the dollar index fell to a low of 99.02, closing at 96.09.

This correction is expected to be a temporary phenomenon, since one certainty in financial markets is that divergence of monetary policy always eventually favours the currency with the higher interest rates.

Inflation could be out of control no matter where you live

For as long as most traders can remember, the Eurozone has travelled at two paces. No matter which of the various crises that have threatened to engulf the Region in its relatively short history, the pace of recovery has been uneven and in some cases uncertain.

Now, it is not the pace of the rate of recovery that is being questioned, but the factors that are affecting everyone and how they should be dealt with.

While the ECB concentrates on growth and the recovery of activity, a few of the more hawkish nations are seeing inflation in their countries that is, in their vocabulary, out of control.

That may be true of other nations in the bloc, but those weaker economies are more able to accept higher prices since, for them, it is a return to the old days.

Since the Fed has retired the word transitory when discussing inflation despite it still being in use in the Eurozone and in some circles in the UK. a much used expression that accompanied descriptions of the Eurozone in the early days looks set to return.

One size does/does not fit all was the term used to describe expecting countries with high interest rate and high inflation economies to comply with a low interest rate/low inflation strategy.

In order to ensure that the economies in the south of the region didn’t boil over, the growth and stability pact was introduced. This created financial penalties for those countries who exceeded debt to GDP ratios and saw their budget deficit rise above 3%.

However, Spain and Italy, in particular, were unable to comply with those restrictions and were constantly at loggerheads with Brussels, due mainly to the bloated size of the public sectors with various conditions such as pension rights built deep into their economies.

Now, the growth and stability pact has been largely ignored, and it will undoubtedly fall to Christine Lagarde to bring these wayward economies back into line when the time comes.

It is hard to create a scenario in the current interest rate environment where the euro can do anything but correct short-term weakness as it slowly weakens in the long-term.

Yesterday, the single currency saw one such correction, rising to a high of 1.1342 and closing just four pips from the high.