Three Questions: Week of May 09
Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.
Here are some of the things we'll be watching this week (please note that we will be off next week, returning on Monday, May 23):
1. Could slowing inflation numbers signal “peak hawkishness” for the Fed?
Even as consumers have grown more fearful, Wednesday’s US inflation release for April is expected to show a month-over-month decline in both headline and core measures. Gains in food and shelter components are unlikely to offset falling used car prices, and seasonal adjustments will magnify the month’s drop in gasoline costs.
This moderation in price pressures isn’t likely to bring out the doves at the Federal Reserve.
Volatility in interest rates typically falls as tightening cycles progress - and investors already assume the federal funds rate will climb aggressively in the coming months, making it more difficult for officials to continue “outhawking” markets or exceeding expectations.
But with central banks facing the biggest challenge to their credibility in a generation, policymakers will feel compelled to continue the tough talk. Last week’s short-lived market reaction - when yields plunged and financial conditions loosened on Chair Jerome Powell’s reluctance to endorse 75-basis point hikes - illustrated the perils that can come with any perceived dovish tilt.
Instead, we expect Fed speakers to work on ratifying implied pricing levels for the front end of the curve, while nudging longer-term neutral rate expectations upward - doing their utmost to convince the general population that they are serious about tackling runaway inflation.
Because ultimately, this isn’t a battle being fought among hawks and doves on the Fed’s policy committee - it’s a game of chicken played between central banks and consumer inflation expectations.
- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST
2. What will data and ECB-speak tell us this week?
That there’s a strong push for a rate hike in July, but not yet enough of a plan on Eurozone spreads - a combination that might support the euro but will fall short of turning it around.
This week will see the release of final April inflation data from three key Eurozone members – Germany, France, and the Netherlands – as well as the March industrial production print for the entire region. The numbers will likely confirm that the Ukraine war is pushing prices higher and production lower - a mix that will fuel debate within the European Central Bank on how to tighten policy while supporting the underlying economy.
Upcoming speaking engagements will help flesh out the terms of that discussion, but recent outings have made it clear that President Christine Lagarde faces a large and vociferous group of hawks, including within the Board.
There is an unexpectedly broad front eager for - or at least open to - a July hike. It goes beyond the northern European national central banks to include Isabel Schnabel (German board member but not originally from the Bundesbank), the head of the Banque de France, and ECB Vice President Luis de Guindos (formerly Finance Minister of Spain). In addition to inflation expectations, they also believe (correctly in our view) that in a world beset by negative supply shocks, euro weakness will hit sentiment and real incomes far more than it will boost exports.
This makes it increasingly likely that the first quarter-percent rate hike could be teed up on June 9 and formally announced on July 21 - a move that might appease those who want to move early, while preserving the flexibility needed to adjust direction later in the year.
Front-end rates are not the only question, as ten-year Italian yields cross the 3.0 percent mark. Given that the country’s debt profile has an average maturity of 7 years, the immediate consequences might not be too damaging, but the size of its debt stock makes spreads and debt sustainability a perennial concern. The ECB has moved along from Lagarde’s unfortunate “not here to close spreads” comment two years ago and has made it clear that it is ready to do so, albeit via euphemisms such as “unwarranted fragmentation of the monetary transmission mechanism.”
But the Bank has been less forthcoming on methods. So far, officials have referred to reinvestments of maturing securities bought under the Pandemic Emergency Purchase Program, but the size and timing might not be enough at high stress moments. They have alluded cryptically to unspecified new tools, but as yields and spreads rise, markets are likely to want more details. And the eagerness to move fast raises the question of whether it makes sense to insist on ceasing asset purchases altogether (only to potentially restart them under another guise) as a necessary precursor to rate increases.
It's going to be a busy month for ECB messaging.
- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST
3. Can the pound catch a break this week?
The British pound suffered a brutal selloff in the first week in May, turning in the worst performance among G10 currencies as it lost 1.8 percent against the dollar and 1.85 percent against the euro. But politics or first quarter growth numbers might provide momentary respite.
The currency’s meltdown happened even as the Bank of England delivered strongly hawkish guidance and hiked rates by 25 basis points, with Governor Andrew Bailey’s repeated concerns about recession risks doing most of the damage.
Policymakers now expect inflation to remain high even as the economy enters a sharp slowdown beginning in the second quarter, forcing the central bank to continue raising rates.
This is clearly bitter policy medicine to digest.
But business confidence remains high and details of first quarter growth may offer some hope of ongoing momentum.
The ruling Conservatives lost over 500 seats in local elections last week and many are angry not just at Boris Johnson over “Partygate” but also at Chancellor Rishi Sunak, who is embroiled in a mini-scandal over his family’s tax bill. Party members are demanding an emergency budget and tax cuts to help the government regain its footing - steps that might reduce some of the fiscal retrenchment now under way.
And the UK is not alone in experiencing a simultaneous squeeze on real incomes and inflation stemming from the war in Ukraine. Europe’s hawks seem ascendant right now (as noted above), but the BoE has its own contingent of the same, and the ECB will take a very long time (if it ever does) to raise benchmark interest rates to British levels.
These are not necessarily long-term considerations but could lead to a near-term market rethink on whether the pound has fallen too far, too fast.
- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST
USD Consumer Price Index, April
USD Department of Energy Weekly Inventories
GBP Gross Domestic Product, Q1
USD Weekly Jobless Claims
MXN Bank of Mexico Rate Decision
USD Baker Hughes Weekly Rig Count
“The sums of money being contemplated in Washington are enormous – a total of $47bn, the equivalent of one third of Ukraine’s prewar GDP. If it is approved by Congress, on top of other western aid, it will mean that we are financing nothing less than a total war.”
“Asia may be the center of gravity of world manufacturing, but European and North American firms still command the bulk of the profits embedded in global supply chains. This tension in the global economy is unlikely to resolve anytime soon, but it has become increasingly fractious.”
“We find that inequality rises following recessions and that rapid credit growth prior to recessions exacerbates that effect by around 40%.”
“A $100 decline in housing-market net worth, according to one U.S.-based study, lowers consumption by $2.50-5.00. In China, the housing wealth effect is likely at least this large. As the right-hand chart above shows, homes represent roughly 45 percent of Chinese household net worth. (In some cities, it is more like 70 percent.) That compares with just 27 percent in the United States.”
“There are parallels with the dot-com bubble that burst in 2000. In both episodes, technology did fundamentally alter our way of life, but the market, aided by the Federal Reserve’s easy money, drove stock prices to levels that assumed these trends would continue indefinitely. They didn’t.”
“If we have spent the past 40 years building a giant imbalance between capital and labor this reversal is ultimately a good thing. But it’s not going to make capital happy. If you have been an outsize winner for the past decade, you’re probably going to moan about it when the imbalance narrows (hey it’s understandable that we respond to marginal changes to our situation, but it’s not reasonable to miss the big picture that prior wins have been out of proportion to contribution). What was given to you easily by the Fed’s support of high duration bets, can be taken away. Don’t expect sympathy.”