6 May 2022: Sterling collapses after dovish hike

Questions being asked about seriousness of inflation fight

The Bank of England raised interest rates for the fourth consecutive time at its meeting which concluded yesterday.

The base rate now stands at one per cent, its highest level since 2009.

Bank of England Governor Andrew Bailey spoke in his post meeting press conference of his belief that inflation will reach a peak of 10% in the summer.

Bailey also warned of a major slowdown in the economy, made worse by the continued conflict in Ukraine and the prospect of further rises in the price of energy as the cap is raised further in the Autumn.

Bailey believes that there is a narrow path to be negotiated between high and rising inflation and a potential recession. Most observers will see that path narrowing almost by the day. The continued effect of lockdowns in China on supply chains is also a contributing factor to the slowing economy.

With inflation set to reach its highest level since 1982, it will take several more monthly increases of twenty-five basis points to make a dent in rising prices, but the Bank has its hands tied to a large extent by fears that stamping down hard on the brake will tip the economy into a recession that would be both harsh and long-lived.

It appears that the new normal means that the Government is called upon at every opportunity to bail out those most affected by the slowing economy.

The Chancellor will point to the current level of employment to show that there is little that can be done in the short-term, despite business investment being set to plummet as firms concentrate on survival rather than expansion.

Coming at the end of the Pandemic and the high level of support that was necessary at that time, the Government’s rather weak message is that we are all in this together, although that is never an easy pill to swallow when the Conservative party is in power.

The Shadow Chancellor Rachel Read predictably called for a windfall tax to be levied on the profits of energy companies. She believes that such a move could produce a reduction of £600 in household energy bills over a year. With households facing the biggest squeeze on incomes since 1964, the calls for action may become impossible to ignore.

The pound is bearing the brunt of the market’s concerns that a recession could be seen in Q3. Yesterday it fell to a low of 1.2325 versus the dollar and closed at 1.2360. The picture was similar versus the euro, with the pound closing at 1.1724.

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Hawkish market concerned about Fed Chair’s seriousness

Questions are being asked about why Fed Chairman Jerome Powell found it necessary to rule out the possibility that a seventy-five-basis point increase in interest rates may become necessary in the coming months if the Fed’s current strategy fails to bring inflation back down to more acceptable levels.

It is harsh to question the commitment of Powell and his colleagues on the FOMC to lowering inflation, and such comments appear to be little more than the unfounded criticisms that are usually directed at a Central bank when it finds it necessary to begin to hike rates.

Before Wednesday evening’s press conference, no one had felt it necessary to even consider hikes in excess of fifty basis points, so it seems that Powell has simply given the market a stick to beat him with.

Fundamentally, it is hard to label the most recent FOMC meeting as anything other than a success. Powell delivered the rate increase that was promised at the IMF meeting and confirmed that the reduction of the Fed’s balance sheet would begin next month.

He even gave sufficient advance guidance that there will be another fifty-basis point increase at the next meeting.

Speculation continues about what FOMC members see as the neutral level for short term interest rates, although this is something of a moot point as no matter what the neutral rate is, it is almost certain to be exceeded as the fight against inflation intensifies.

It seems that the futures markets were quietly pricing in the possibility of a marquee hike of seventy-five basis points at either the June or July meeting, although Powell did all but promise a hike at both meetings.

The press has come down heavily on Powell’s supposed dovishness, although since he switched from economic supporter to inflation fighter, he can hardly be accused of that.

Market reactions to the hike remain, although attention will now switch to today’s employment report for April.

Median forecasts for the headline non-farm payrolls are for close to 400k new jobs to have been created. This is not expected to be massively different to the figures for March.

The dollar index recovered from its knee-jerk reaction to the FOMC meeting. It rose to a high of 103.94 and closed at 103.57.

Euro at five year low but in good company

We should call it out for what it is. Despite official denials, the economy of the Eurozone is experiencing stagflation.

Since this is not a condition that is either welcomed nor common, commentators appear to be shying away from calling a spade a spade.

Inflation is high and rising, while the economy, not experiencing the official definition of a recession, is slowing at an alarming rate.

This week’s data for retail sales combined all the effects that are afflicting the economy at the moment. Consumer confidence in the more affluent members of the Union is plummeting as the price of energy skyrockets.

The announcement of a sixth round of sanctions against Russia has brought further uncertainty. Despite its apparent agreement with the move, Germany has already commented that it will find it virtually impossible to function without Russian oil and gas.

While it is never easy to announce sanctions on imports, since they tend to affect both parties, it is easier to announce that imports of energy will be curtailed in May, just as summer is arriving, than it is in September or October, when households are beginning to consider turning up the thermostat.

Ever since the Pandemic began, the European Union has developed a habit of trying to avoid the inevitable. It happened in the piecemeal introduction of lockdowns which saw individual nations introduce their own policies and continues as the sanctions receive individually derived responses.

Of course, it would be impossible for any country or group of countries to simply introduce sanctions on energy imports effective immediately. However, announcing a timetable without any concrete plan appears to have been done more in hope that it may not be necessary than expectation that it will become inevitable.

Individual data points are becoming little more than indicators on the path to a recession in the Eurozone, which is now almost inevitable.

The expected hike in interest rates will most likely be seen as a sop to the frugal five and while it is hoped that raising rates will go some way to slowing inflation, it will be some time before rising prices return to the Central bank’s target since the majority of any fall will have to happen naturally.

The euro faces continued pressure as it travels, almost inevitably, towards parity with the dollar.

Yesterday, it fell to a low of 1.0492, but recovered to close at 1.0541.

It is interesting to note that since April 28th, the daily lows for the single currency have been 1.0471, 1.0491, 1.0490, 1.0492, 1.0506, and 1.0492.

There is clearly a significant buy order around that level, but when it is exhausted, the euro may play catchup with the more significant fall that has been experienced by the pound this week.