Neil Parker, our FX Markets Strategist, shares his views on the currency markets this week
United Kingdom: Bank of England hold rates; GBP and yields collapse
It was always likely to be an interesting week in the UK. Even before the Bank of England’s (BoE) decision on Thursday, the economic evidence continued to pile up in support of a resurgence of economic growth. Both the manufacturing and services PMIs (Purchasing Managers’ Index) for October were revised up from their preliminary readings, and the October construction PMI also reported a stronger than expected expansion. Inflation pressures in the manufacturing space remained geared towards higher input versus output prices, something that could prompt price hikes throughout the supply chain in the months to come. There was also further evidence that the UK housing market continued to endure a lack of housing stock, forcing up prices yet further.
It was against that backdrop that the Bank of England met. The Monetary Policy Committee chose, on balance, to leave interest rates on hold and continue with the asset purchase programme (APP) unchanged, although two members (Saunders and Ramsden) dissented on the rate decision, and three on the APP (Mann joining the other two). The markets were taken by surprise, since interest rate markets were convinced that a hike was coming in November, and GBP and yields fell sharply in the aftermath. Although BoE Governor Bailey suggested the decision had been a close call, a hike in December is still more unlikely than likely. The BoE will want to see significant further signals of economic improvement, and the Chief Economist, Huw Pill, has suggested that consumer confidence might hold the key. Given that has slumped over the past four months, I’d suggest a hike in February is far more likely.
The drop in the GBP after the BoE decision leaves sterling vulnerable heading into the year end, and the risk of a repeat of the disappointment in December only heightens that risk in my eyes. GBP/USD and GBP/EUR have swiftly ceded large chunks of recent gains, suggesting the purchases were built in part on unrealistic interest rate expectations.
This week, the attention swings back to the data releases. There are a slew of figures released on Thursday relating to the performance of the UK economy in Q3. The pace of expansion is expected to have slowed sharply from Q2’s 5.5% quarter-on-quarter increase, but by how much? My gut instinct suggests growth will be weaker than consensus forecasts for growth of 1.5% quarter-on-quarter, as supply chain disruption and falling consumer confidence dented activity. The confirmation that the furlough scheme would be brought to an end at the conclusion of the quarter could have slowed consumer spending as well. The UK data and survey releases risk a sell-off in the GBP, in my view. One counterbalancing factor might be the rebuilding of interest rate expectations, which could see yields recover some of the losses at the end of last week.
United States: Federal Reserve’s taper begins; payrolls fizzle
There were two big events last week. The first was the US Federal Reserve’s monetary policy meeting, which concluded on Wednesday with an agreement that the asset purchase programme would be wound down, beginning immediately with a $15bn reduction in asset purchases, taking the monthly limit from $120bn to $105bn. The Fed also stated it intended to reduce the purchases by a similar amount in December, when the latest round of interest rate forecasts from Fed members will be released.
The second was the US October non-farm payrolls data, which recorded a 531,000 increase in net payrolls, after a revised 312,000 rise in September (up from 194,000). The unemployment rate dropped to a fresh post-pandemic low of 4.6%, average earnings growth crept up to 4.9% year-on-year, but crucially the labour force participation rate remained stubbornly at 61.6%. It is likely that jobs growth could have been even stronger were it not for a limited labour supply, which could mean more persistent domestic sources of wage inflation unless the labour supply improves. There was nothing in the US labour market data that undermined the case for a rapid taper of the asset purchase programme.
This week’s key US releases include October consumer price inflation, the October monthly Budget statement, and the provisional November consumer sentiment survey from the University of Michigan. Inflation is forecast to rise to close to 6% on a headline basis, the October fiscal deficit is set to fall, versus last October, but be around 30% higher than the 2019 deficit figure, whilst consumer confidence is predicted to have risen, if only a little. For the USD, recent constructive labour market data aside, the recent sets of disappointing activity data coupled with weak consumer sentiment are constraining additional upside, in my view.
Euroland: figures disappoint; EUR struggles persist
A whole plethora of surveys were released last week and, on the whole, they recorded additional disappointment in terms of the pace of activity expansion. The final October PMI surveys recorded a slight slowing in the pace of expansion for manufacturing and services versus initial estimates, which was disappointing given the improvements viewed in the UK surveys. There was an improvement in the Euroland unemployment rate in September, but the drop to 7.4% was expected.
The real frustration came when the German and French industrial production figures were released on Friday. Ahead of them, German factory orders data for September had recorded a more modest recovery, but only after August’s figure had been revised from an already disastrous -7.7% month-on-month to an even worse drop of 8.8%! So perhaps that was a sign of the flop to come, but it was no less painful. German industrial production fell -1.1% month-on-month when it had been expected to recoup at least part of the 3.5% drop recorded in August. French industrial production dropped 1.3% month-on-month, more than wiping out August’s 1% gain. Supply chain issues were a key driver behind the underperformance, and could prove to be inflationary if they persist.
For this week, we’ve already had a surprise improvement in the Euroland Sentix investor confidence index for November, which rose from 16.9 to 18.3, having been predicted to drop again. Could that be the signal of improved fortunes to come for Euroland economies, who are facing increases in Covid infections once again. The main release of significance for this week is Tuesday’s release of the German sentiment index, ZEW (Zentrum für Europäische Wirtschaftsforschung) ZEW survey for November. Could that spring a surprise and fall less than expected, or even rise? If it does report an increase in either the current situation or expectation indices that could offer the EUR some much needed support. On Thursday the European Central Bank releases its latest economic bulletin, whilst the EU Commission's Autumn forecasts will update markets on the pace of recovery for Euroland and European Union economies. There’s a chance, albeit a slim one, that the EUR could make some gains against the likes of the GBP and USD this week.
Central banks: Poland and Czech Republic break out the monetary policy sledgehammers; focus shifts to Romania, Mexico and Peru this week
Amidst all the interest around the US Federal Reserve and UK Bank of England decisions, there were some very important meetings elsewhere. The Reserve Bank of Australia kicked things off by leaving policy unchanged, and remaining somewhat dovish in terms of the outlook for the macro economy. The National Bank of Malaysia followed suit shortly after, rates left at 1.75% and indicating that the outlook for inflation remained benign.
Things heated up quickly thereafter though, with first the National Bank of Poland hiking interest rates by 75 basis points to 1.25% on Wednesday, and then on Thursday the Czech central bank hiking interest rates by 125 basis points to 2.75%. NBP Governor Glapinski tried to calm markets, suggesting that "everything indicates" no need for additional interest rate hikes. The Czech central bank was far less conciliatory, suggesting more rate hikes to come, albeit of a smaller order of magnitude.
This week, we are likely to see hikes from the central banks of Romania, Mexico and Peru. The outlook for interest rates will continue to be governed by the inflation environment, which still appears to be deteriorating in a number of developing economies. There is a risk that these central banks will hike by more than is priced in, which could have a significant effect on currencies as we head into the year end.
View last week’s Quick take.
For more FX views and insights, visit our FX Insights Hub.