19 August 2022: Market foresees far higher rates

GBP – Monetary policy to slide into restrictive mode

Following this week’s publication of inflation data for July, there is a view growing among analysts that the Bank of England may be forced to raise interest rates to a level above 3% to bring rising prices back under control.

It is expected that at its next meeting, the Central bank will add another fifty basis points to bring the base rate to 2.25%, with another two further fifty basis point hikes to follow.

Such a move will certainly contribute to a recession which Governor Andrew Bailey has predicted will arrive in the fourth quarter and could last through the whole of 2023.

If inflation can be brought under control, the bank may be able to begin to lower rates to provide a degree of support for the economy by the third quarter of next year.

With the Conservative party leadership contest to be completed in a little over two weeks, the current underdog, Rishi Sunak, who has trailed in the polls since the race was reduced to two contenders, still believes he can become Prime Minister on September 5th.

With Liz Truss’ tax cut pledges having been labelled unrealistic, Sunak is concentrating on his vow to see inflation brought under control before he introduces any cuts of his own.

His biggest fear right now is the increase in the energy cap which will see household bills reach around £3.5k with a further increase already announced by OFGEM for January.

While neither candidate has responded publicly to the call from Opposition Parties for the increase to be scrapped and a six-month moratorium introduced, it is understood that both have pledged in private to investigate such a move.

Data for retail sales will be released later this morning, with the data set to be weak but not as bad as has been seen recently. Year-on-year retailers are expanding a fall of 3.3% following a fall of 5.8% in June.

The pound crashed through the 1.20 level versus the dollar yesterday as risk appetite fell following concerns over falling output from the Chinese economy, where the Central Bank cut interest rates to stimulate growth.

Sterling fell to a low of 1.1922, closing at 1.1929. The current range bound trading is set to continue for a further week until the summer lull ends.

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USD – Jobless claims almost unchanged

The FOMC has acknowledged that the housing market will be the first to be affected by its continued tightening monetary policy, and this week has seen activity across the entire sector.

Building permits and new home starts were released earlier in the week and saw moderate falls while existing home sales data was released yesterday. Sales fell from 5.11 million in June to 4.83 million in July.

Rising mortgage rates are persuading those who were considering a move to defer such a decision until the Federal Reserve decides that it has brought inflation back under control.

With interest rates considered to be at a neutral level currently, and inflation continuing to rise it may be that there is a significant period in which rates are restrictive.

This week’s release of minutes from the latest FOMC meeting were inconclusive, although given the continued strong jobs data, the market believes that there could be between 100 and 150 basis points of further hikes before the end of the year.

The minutes did hint at a hike at the next meeting which takes place on September 20/21 with consideration then given to a pause for reflection. With inflation showing no sign of abating, that view may have changed between the meeting and the release of the minutes six weeks later.

The Committee will have had the opportunity to see two sets of employment and inflation data between meetings but since they are both data driven and not sways by any single off-trend reading their view is unlikely to change before the September meeting.

The minutes did indicate that the previous two seventy-five basis point hikes won’t be continued, as the Bank continues to tighten policy, but will take an opportunity to study the effect of recent actions.

A fall in global risk appetite saw the dollar index begin to head north again yesterday. It rose to a high of 107.56 and closed at 107.51.

Next week, the last before Labor Day brings the summer to a close, will see data for durable goods orders, further housing market, and personal consumption expenditures released. The PCE data is the Fed’s preferred measure of inflation.

For now, the effect of Central Bank action is having less of an effect on FX rates since all the G7 except for Japan is in the throes of tightening policy.

EUR – Record inflation to force tighter monetary policy

With output across the entire Eurozone threatening to fall off a cliff, and a real possibility of energy rationing taking place in Germany, the ECB is facing its most crucial decision ever at its next rate-setting meeting, which will take place in the second week of next month.

The average inflation rate for the Eurozone rose in July to 8.9%, just shy of four and a half times the bank’s target.

While this is the average, there will be as many nations where prices are rising at an even faster rate as there are where rises are more moderate.

Nonetheless, the ECB is likely to hike rates by a further fifty basis points and could face pressure to tighten even more. Having managed to avoid a technical recession having seen a tiny amount of growth in Q2, the region is unlikely to avoid contraction over quarters three and four.

The use of the measure of two consecutive quarters of contraction that has been in place for many years has been called into question recently.

In the U.S. where there was contraction in Q1 and Q2, the Fed insists that the economy is not in recession, while in Europe, there have been two consecutive quarters of growth yet every other measure points to the economy being in recession already.

Not only did headline inflation rise significantly in July, but the core also rose, to 5.1%, which is two and a half times the target.

Christine Lagarde has used the plaintive cry that the Bank has changed its measure, to use an average of 2%, and since inflation has remained below 2% for a considerable time, there is a degree of leeway for it to rise.

The markets are not buying this as an excuse and will continue to pressure the single currency towards parity and below.

Several analysts have a target of 0.95 for the euro before it manages to rebound, but many see that as being a little too conservative, with the all-time low now being mentioned as possible.

Yesterday it fell to a low of 1.079 and closed at 1.0089.

Next week will see the release of output data for both Germany and the wider Eurozone, both are expected to show continued contraction.