23 February 2023: Turnaround gives Hunt wiggle room

The turnaround in the UK economy in the first two months of the New Year has been nothing short of miraculous. Both manufacturing and services output have returned to expansion, while the Government has found some spare cash with which it can do some good.

There is speculation that Rishi Sunak intervened personally to offer salary increases of 3.5% to millions of public sector workers. He remains adamant that any increase of above 5% would drive further inflation, but 3.5% is doable.

The Royal College of Nursing has called off its latest industrial action, which was due to take place next week and last for 48 hours. While this is positive, there is no guarantee that the latest offer, that has already been rejected by the union representing ambulance crews, will be accepted.

From the release of GDP data for the fourth quarter to the PSBR and encouraging output data, there is a genuine feeling that the country is finally on the right track.

While a threatened return to the political front line for Boris Johnson in the summer is being predicted, if confidence is growing in Rishi Sunak’s performance any comeback will be that much more difficult, no matter the level of support he enjoys from the Conservative back benches.

Citibank, in its latest economic forecast, believes that inflation can return to 2% in the Autumn if the Bank of England can hold its nerve, although the current crisis that is now seeing all the major supermarkets ration sales of several fresh food items may provide further short term issues and drive food price inflation.

With the base rate now at 4% and set to rise further next week, it is believed by several economists that it is now at a level which will restrict demand and begin to significantly affect inflation.

The market should guard against getting ahead of itself following a very strong week for the economy, but there are conversations now being had about when the Central Bank will be able to begin to lower interest rates.

That is unlikely to be possible or even supported by the monetary policy committee before the end of the year, but heading into the final year of this Parliament it will give the Conservatives renewed vigour with which to fight the election.

The pound is building a solid base as it moves away from the 1.20 level, which provides significant support versus the dollar. Yesterday, it rallied to 1.2135, but the dollar recovered later in the day as the minutes of the latest FOMC meeting were released, and it drifted back to close at 1.2043.

Versus the euro, the pound is struggling as the single currency benefits from its own recovery and the prospect of significantly higher interest rates. Following a strong performance earlier in the week when it reached a high of 1.1377, it has gradually drifted lower, and yesterday it closed at 1.1358.

This week has seen a possible return to the Cold War, with Russia accusing the west of creating the conditions which left it with no alternative to protect its borders by invading Ukraine, while President Biden countered by vowing to stand shoulder to shoulder with its European allies in protecting NATO’s eastern border.

Senior Russian and Chinese diplomats and government officials held their first meetings in several years, which was also seen as a threat to peace in Europe.

Biden promised further financial support to President Zelensky, but remains reticent to agree to the supply of American planes.

The effect of risk appetite will provide further support for the dollar going forward, as the release of the minutes of the latest FOMC meeting provide little clarity over the Fed’s intentions.

It is interesting to note that despite its Chairman’s reservations and several members of the committee voting for a fifty point hike, the majority decision was for a twenty-five point hike.

The reason that a majority of Regional Fed Presidents lowered their votes to twenty-five basis points is the view that there is a marginally heightened risk of a recession later in the year.

There is a perception growing that the February hike will be a one-off, a testing of the water if you will, to gauge the reaction of the market to the time when the Fed feels more confident to taper to do away with rate hikes entirely.

Jerome Powell’s assertion that the Fed will remain driven by the data, may well see a fifty point hike agreed at the meeting that will take place on March 21/22. A lot will depend on the February employment report and the continuing fall in inflation.

Should there be a significant revision to the January NFP data or February’s data show it to have been a one off the Fed may stick another twenty five points. However, given time to consider the majority of the February they may well want to show they are still to be considered tough on inflation.

The dollar index continued its slow progress towards a test of minor resistance at 104.80 yesterday. It reached a high of 104.58 and closed at 104.53.

Christine Lagarde may have felt somewhat chastened by the criticism of her testimony before the European Parliament recently in which she left no one in any doubt that the ECB will hike interest rates by a further fifty basis points ate its next governing council meeting, but she continues to be forthright in the views and feels encouraged to express them.

Yesterday, she offered something of a counterbalance to her more hawkish tendencies by downplaying the effect of rising incomes on inflation by saying that rising pay is merely the market playing catch up, following a year in which real incomes have fallen dramatically.

She is confident that as inflation falls back towards the Central Bank’s target close to 2%, so wage demands will also abate.

She does not anticipate the start of a wages/prices spiral, since it would require inflation to remain well above target for a considerable time for this to occur.

Lagarde spoke of her feeling of sisterhood , being just one of two women of the Governing Council, implying that the hawkish nature of recent meetings was due to a surplus of testosterone.

It is ironic, therefore, that the other female member is one of the most hawkish, the German Economist Isabel Schnabel.

Lagarde’s recent comments on interest rates have left the markets with little need to speculate on their future path. The only issues to be considered is at what level rates will be restrictive to demand and when will the policy of further rate hikes come to an end. There is some expectation that these questions will be answered at the next meeting in the middle of next month.

The euro is attracting some support from the ECB’s interest rate policy, but with the Fed taking a marginally more hawkish stance, the single currency is not making any real headway.

Yesterday, it returned to the bottom of its recent range, falling to 1.0599 and closing at 1.0602.

The feeling in the market is that G7 Central Banks are coming to the end of their rate hike cycles and their currencies will be driven by the first one who actually confirms the end of the current cycle.

Have a great day!