United Kingdom

Bank of England to hike a further 25 basis points

Last week saw fairly little data or surveys for the markets to move on, but the survey evidence published indicated that the UK economy is continuing to suffer under the collective weight of excessive inflation and interest rate hikes. New car registrations in May were down over 20% year-on-year, a worsening of conditions since April, whilst the British Retail Consortium’s May sales monitor reported like-for-like sales values down 1.5% year-on-year, though May 2021 was the first full month of non-essential retail reopening post the second lockdown. There was some good news in terms of the final-May Chartered Institute of Purchasing and Supply services Purchasing Managers’ Index (PMI), which was upwardly revised to 53.1 from 51.8. But that was quickly superseded by the May Royal Institution of Chartered Surveyors house price survey, which reported a sharper than expected drop in the sales balance, to 73 from 80 – the weakest reading since December, when the index was at 69. The Bank of England/Ipsos inflation expectations survey for May reported a further increase to 4.6% for the next 12 months, up from 4.3% in April.

The pound came back under pressure against the US dollar last week dropping below $1.2350 having been at a high of $1.2667 only two weeks earlier. Alongside the economic surveys there was also a sharp reduction in risk appetite, demonstrated by a drop in equity values towards the end of the week. That weakness in GBP has continued in the early part of this week, with GBP-USD dropping below $1.22, and that despite the further upward march in UK yields and interest rate hike expectations.

Already this week, monthly Gross Domestic Product (GDP) figures for April have given the Bank of England a potentially larger headache. The data reported an unexpected drop in UK economic output of 0.3% month-on-month, with all the key categories of production (services, industry and construction) reporting falls from March. Notably the decline in services activity compounded on a weak March outturn, suggesting a rapid pull back in services activity as the costs of necessity goods rise. It appears that the Bank of England’s gamble, on savings supporting consumption in the near term, isn’t paying off. 

Later this week, the Bank of England meeting on Thursday is the key event, but there are further data releases that will be of interest to markets. On Tuesday, the latest labour market figures are released. Will the claimant count continue to fall in May, will employment have recovered again in April and will average earnings continue to rise? On Friday, May retail sales data will be closely watched, and in particular spending on discretionary goods will be the focus. Will consumers abandon discretionary goods purchases as incomes remain under pressure, or will there be some stockpiling ahead of further anticipated price increases? The danger the UK faces is that the consumer has already altered behaviours, and so a recession is inevitable. That risk is not fully appreciated by the Bank of England, who are expected to hike interest rates by 25 basis points on Thursday. The World Bank recently indicated that the risks of stagflation were rising globally, but the UK was singled out as the developed economy at greatest risk.

As for GBP against other majors, the pain is likely set to continue in my view. The economic news is set to worsen, higher yields are providing the GBP with no support and other central banks may be even more aggressive than the Bank of England can, or should, be with interest rate hikes, in my view. A push beneath recent lows in GBP-USD at $1.2156 would open the door towards a move to $1.18, whilst in GBP-EUR any chance of a retest back above €1.1950 looks to have been quashed, and the risk is a drop towards €1.14 over the coming weeks and months. 

United States

US Federal Reserve to hike 50 basis points even after further slump in the consumer sentiment

The US Federal Reserve will make its monetary policy announcement on Wednesday at 19:00BST. The markets are broadly unanimous in expecting a 0.52 percentage point hike in the targeted Fed Funds rate, taking the upper bound to 1.5%. Those expectations were cemented at the end of last week, when the consumer price inflation figures for May reported the headline rate rising to 8.6%, and although the core inflation rate fell, to 6%, that was less than the market consensus anticipated. That said, the Federal Reserve continue to ignore the sharp deterioration in consumer sentiment and housing market indicators. Those were again apparent last week, with weekly mortgage applications falling a further 6.5% week-on-week, to sit more than 58% lower than where they were at the end of January, whilst the preliminary June University of Michigan consumer sentiment survey reported a fresh record low, dropping to 50.2 from 58.4 previously.

Interestingly, the markets continue to ignore the weak activity and survey data in favour of the inflation strength, but the issues could not be clearer for the US economy, inflation running hot threatens to derail the post-Covid recovery such that a new economic slump is the risk. Markets price in 175 basis points of tightening between now and post the September Federal Open Market Committee meeting, which would take interest rates to 2.75%. Back in 2018, US interest rates reached 2.5% after a series of gradual increases, and then fell back sharply, even prior to Covid. The risk is that the scale of the hikes seen recently may merit a faster pace of rate reductions given the threat of a consumer spending collapse, in my view.

For this week, aside from the Federal Reserve decision and possible guidance over future decisions, we have a whole batch of surveys and data due. Tomorrow’s National Federal of Independent Business optimism index and producer prices data, both for May, should record a drop in confidence, but limited if there’s any pull back in inflation. Wednesday’s weekly Mortgage Bankers Association mortgage applications data, Empire manufacturing survey for June, May retail sales and June National Association of Home Builders (NAHB) housing market index could provide a mixed bag of news, with retail sales holding up, the Empire manufacturing index recovering, but mortgage applications and the NAHB index both declining further. On Thursday, May housing starts, the June Philly Fed business outlook index, and weekly jobless claims could also provide mixed sector-dependent messages, and Friday’s industrial production figures for May could see the week end on a high note, with ongoing strength in industry, despite the weakness displayed by some surveys.

As for the US dollar, I suspect it will hold onto recent strength, with risk appetite in retreat and bond markets pricing in additional rate increases. Against the other majors it will still hold the greatest attraction as a safe-haven, despite many economic problems massing on America’s recovery. The upside for the US dollar, lies in a break back above recent highs over 105 in the dollar index, which could see it rise a further 2-3 percent thereafter, in my opinion.

Europe

ECB readies itself for a July hike

The news from Euroland over the past week was, in the main, disappointing. Germany factory orders and industrial production were both far worse than consensus forecasts in April, but there was an inexplicable upward revision to Q1 GDP growth figures for the whole of Euroland, from 0.3% to 0.6% (quarter-on-quarter). Irish industrial production slumped in April, but there were upside surprises in Dutch, Finnish and Italian industrial production data towards the end of the week, and this morning’s Q1 unemployment data from Italy was also surprisingly robust. Last week’s ECB meeting moved the monetary policy discussion forward, in the regard that the discussion is now about how much tightening is appropriate between now and the end of 2022.

With the ECB gearing up for sustained monetary tightening, you might expect the EUR to have performed better over the course of last week. It lost a lot of ground however, and now lies less than 1% off recent lows against the US dollar, with further pressure being exerted as US interest rate hike expectations increased sharply in the latter stages of last week. If central banks truly want to try and quell the inflation exhibited recently, then interest rates would have to rise considerably higher than they are predicted to go, including in Euroland. A question I repeatedly ask, is how much worse will the macro outlook be allowed to get before the central banks reverse course on current planned interest rate hike activity?

For this week, the German ZEW* survey for June is expected to record an improvement in both current situation and expectations indices, but could there be a nasty surprise from this survey? There is limited other data from Euroland due, although there will be some interest in the aggregate Euroland industrial production and construction output figures for April, released on Wednesday and Thursday, and also the final-May consumer prices data for Euroland, released on Friday. Overall though the data is highly unlikely to alter opinions at the ECB regarding short-term interest rate decisions. All central banks seem to believe that there is a stockpile of savings that will mitigate the worst effects of the inflation spike and interest rate hikes, but I remain unconvinced that the resilience is real.

As for the EUR, there is a risk of a further depreciation against the US dollar, with the drop in risk appetite trumping any benefit that the prospect of higher European interest rates might provide, in my opinion. 

* Zentrum für Europäische Wirtschaftsforschung, Germany’s Sentiment Index

Central banks

Australia and India step up the hikes; Brazil and Taiwan to hike

Last week’s central bank meetings saw the Reserve Bank of Australia kick things off with a 50 basis point hike in interest rates, when only 25 basis points had been expected. That was quickly followed by a marginally larger than expected 50 basis point hike in the Reserve Bank of India’s repurchase rate, when 40 basis points was the consensus. The rest of the week saw the National Bank of Poland hike rates by 75 basis points, as expected, the Peruvian central bank hike by 50 basis points, and then the Russian Central Bank cut interest rates by 1.5 percentage points, which was more than markets expected. The hikes in interest rates in Australia, India, Poland and Peru were driven by an ongoing fear of supply chain-led inflation and concerns over currency weakness (in Poland’s case). As for Russia’s interest rate cut, with the rouble continuing to increase in value, the cut was always likely to be on the larger side, but there is a limit to which these cuts in interest rate will have a positive effect on Russia’s real economy, in my view.

Outside of the two big interest rate decisions from the US and UK, the Brazilian Central Bank are set to hike interest rates to 13.25% from 12.75% on Wednesday, the Swiss National Bank are set to leave interest at -0.75% on Thursday, and the central bank of Taiwan are set to hike interest rates by 25 basis points on Thursday as well. The decisions to hike in Asia are more nuanced, given the ongoing economic and healthcare challenges that Covid poses, whereas the inflation fears in Latin America are the key determining factor for central banks there, in my opinion.