Neil Parker, our FX Markets Strategist, shares his views on the currency markets this week
UNITED KINGDOM: GBP faces ongoing pressure and the potential for greater disappointment
The pound is under pressure. Having failed to make any sustained recovery following on from the falls seen post the US October employment report, GBP last week recorded additional falls prompted by a mix of weaker UK activity data and stronger US consumer price inflation figures. Against the US dollar, the pound reached fresh lows for the year, dropping to a low of $1.3353 on Friday. That’s despite some recovery in UK yields and the repricing of the risk of a rate increase by the Bank of England at the December meeting, although it’s seen as only marginally more likely than on the 5th November, post the disappointment of no change from the Monetary Policy Committee.
So, will the pound continue to drop in the face of the additional economic challenges? The risks are that the sentiment in the markets has now turned such that the FX markets are likely to continue being US dollar positive into year end, with rate hike expectations in the States building more so than in the UK. GBP/USD risks remain to the downside, with a potential test of $1.33 opening the door to very low $1.30s thereafter. As stated in previous weekly comments, the Bank of England could easily disappoint market sentiment once again at the December meeting, prompting further declines in GBP. Notably though the pound is not underperforming against the EUR though, and that is a bit of surprise given the underperformance in UK interest rate pricing recently.
The signals from the UK economy are mixed, but the markets believe that the threat of higher inflation outweighs any downside risks to UK activity. This week’s data and surveys will potentially play to that theme. The UK labour market figures on Tuesday could report some signs of weakness in hiring in September, as the furlough scheme came to a close, whilst Wednesday’s consumer price inflation figures are expected to record a jump in headline inflation, which could exceed consensus expectations. Attention will then shift to November consumer confidence and October retail sales figures, both of which could disappoint mean forecasts. Those hoping for a GBP recovery, will have to pin them on persistent outperformance of the UK economy versus expectations to rebuild market confidence in a near-term monetary tightening, or at the very least an earlier end to the asset purchase programme.
UNITED STATES: US inflation data prompts an additional revision to US rate hike expectations
The US economy provided its fair share of surprises this week, but the market reaction to the news was, in my opinion, overdone. The US consumer price inflation figures for October were expected to record a rise in the headline rate of inflation, but the overshoot seen in both the headline and core inflation rates spooked the markets. The headline rate rose to 6.2% year-on-year from 5.4% in September – its highest reading in over three decades – and the core rate rose to 4.6% year-on-year from 4% – another 30+ year high. Markets immediately revised their thoughts on US interest rates, pricing in more than 50 basis points of additional tightening by the end of 2022. That is over-zealous in my view, since some of this inflation already appears to be dissipating, and, as we emerge from winter into spring, the pressure from energy prices should alleviate further.
Moreover, the US economy continues to fire warning signals to policymakers. The latest of these was the further drop in consumer sentiment in the provisional November University of Michigan reading. Consumer sentiment dropped to 66.8, a new 10 year low, and this despite the progress seemingly being made in the US labour market. So, the Federal Reserve’s decision on monetary policy, in the short and medium term is anything but a simple one. Weakening consumer sentiment, heading into the most important period of retailing for US businesses, could mean momentum behind the recovery is lost as we approach 2022.
The week ahead has little data of any note due for release. October retail sales and industrial production figures on Tuesday might further undermine the market confidence that the Federal Reserve will sanction a significant and sustained tightening of monetary policy in 2022, but only if they undershoot some consensus forecasts, which is the risk. As for the USD, the weakening of consumer sentiment last week has taken some of the gloss from the USD’s rally against the pound and euro. It still remains in the driving seat though, and further downside in the activity data won’t fully undermine the case for tightening of monetary policy in the eyes of the markets. The fixation with inflation risks the markets continuing to overprice for US monetary tightening, in the short term at least.
EUROPE: EU Commission forecasts dial down growth expectations; inflation concerns mount
The Autumn forecasts from the EU Commission made for interesting reading. Growth for 2022 was revised down, although this may have been a function of slightly improved 2021 growth forecasts. Those downward revisions to 2022 activity were notable in the major economies of France, Italy and Spain, but not Germany, which is still expected to grow by 4.6% in 2022 after much slower growth in 2021 (now forecast 2.7% versus 3.6%). The rebound in 2022 in Germany could still be blown off course, given the further surge in wholesale prices in October, up 15.2% year-on-year (13.2% in September), rising Covid infection numbers, and the need for ambitious growth plans from the new German coalition government.
The outlook for the Euroland economy is still the most positive amongst the major economies, but there is a risk that the same supply chain issues that have been disruptive to the US and UK recoveries could undermine the Euroland rebound as well. Given the later start to the latest phase of the upturn, Euroland should carry economic momentum into 2022, which might be more than can be said for the US and UK. Note that Euroland Q3 growth is set to be significantly above what was seen in the UK and US in Q3 when that data is revised on Tuesday and could yet outperform consensus expectations.
The EUR’s performance remains disappointing. It may have just about stopped the bleeding against the likes of the GBP, but it hasn’t enjoyed a material improvement in valuation and fell further against the USD this week. There remains short term downside risk to the EUR, unless there is a marked improvement in the economic data, or the European Central Bank shifts its attitude towards the nature of the current inflation shock. Without either, or both, of these we could see fresh lows in EUR/USD, despite what appears to be an ongoing improvement in risk appetite.
Central Banks: More surprising rate hikes last week; this week’s decisions provide further risks
Last week saw another Eastern European central bank surprise, but this time in a different direction, hiking by less than was expected. Romanian interest rates had been expected to climb to 2% from 1.5%, but in the end only rose to 1.75%, as central bankers wanted to keep the recovery on track. The Bank of Thailand left interest rates on hold soon after, whilst Banxico (the central bank of Mexico) and the Peruvian central bank both hiked, by 25 and 50 basis points respectively, as their concerns over inflation remained.
For this week, we have the Hungarian central bank leading off, and it is expected to raise interest rates a further 30 basis points, but could it be more after the Polish and Czech central banks hiked a few weeks ago? The Icelandic central bank have been raising interest rates steadily, in order to stem a housing boom, but may not go again this month. Following on from that is the Bank Indonesia meeting, which is expected to leave rates on hold.
After that, it gets more interesting, with the central bank of Turkey. Consensus expectations have interest rates falling by 1 percentage point to 15% on Thursday. However, given the sell-off in the lira, and the increase in inflation expectations, an increase might be warranted, but what Turkish central bank Governor wants to get on the wrong side of President Erdogan? The decision will likely be as much about politics as it will economics. A larger reduction in interest rates is only likely to fuel the weakness of the Turkish lira further, so the Turkish central bank will likely tread cautiously.
Finally, the South African Reserve Bank are set to increase interest rates to 3.75%. The decision driven by a spike in inflation, which may prove temporary, but will be of concern nonetheless to a central bank which has faced significant inflation problems throughout the past few decades.
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