FED & BOE preview: What next for USD and GBP?
09:59, 15 September 2022
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It’s been almost two months since we’ve had an all-exciting Federal Reserve meeting and markets continue to price in peak hawkishness from the monetary policy committee. That has obviously been helped by the recent bold interest rate hikes delivered by other central banks, including a surprise 75bps hike from the European Central Bank (ECB) just over a week ago.
Powell and his team have been on a clear hiking path since the beginning of the year as inflation soared well above its key target, but the recent drop in CPI data in July led many to believe it was time for the bank to start lifting its foot off the hiking pedal. But the latest print released this week showed that consumer prices were once again on the rise in August, highlighting the detrimental effect rising costs of living are having on consumers.
In fact, core inflation came in substantially above expectations, increasing 0.6% month over month, compared to 0.3% expected. Headline inflation, which includes volatile prices of energy and food, rose 0.1%, compared to a 0.1% drop expected, which highlighted that the uptick in prices has come from more sticky areas like transport, housing, and medical expenses. This falls in line with the recent drop in energy prices and makes the FED’s job of balancing inflation and growth more important.
Economic projections
Some wonder whether higher unemployment will be needed to curb inflation, given the growing pressure of wage inflation on the economy. The unemployment rate in August came in at 3.7% and the Fed’s median forecast for unemployment released in June’s projections sees it peaking at 4.1% by 2024 in order to bring inflation back in line with the Fed’s 2% target.
This leads to a disparity in the data if nothing changes. Either inflation starts to be tamed elsewhere or we see job losses in greater force. Because of this, it will be interesting to see what the Fed’s updated economic projections are at next week’s meeting.
But not only are unemployment and inflation key figures to watch out for, economists will also be looking out for the updated projections on GDP. In fact, the US economy has technically been in a recession in the first half of the year, as it saw two consecutive quarters of negative growth. But the reaction to the data was very limited as Treasury Secretary Janet Yellen had already predicted the data would confirm a technical recession. She was successful in deflecting the attention from it, saying that “despite a necessary slowdown in the economy to tame inflation, a true recession is a broad-based weakening of the economy, which we are not seeing right now”.
Recession usually becomes one of the costs of cracking down inflation, and market jitters about the possibility of a slowdown in the next few months have been very present in the performance of riskier and more data-dependant assets like equities and commodities.
That said, prior to the US CPI release, equities seemed to suggest that the US economy may very well be in line with achieving a soft-landing, something Chairman Powell has reiterated in the past but very little saw credibility in his predictions. But the surprise uptick in core inflation has proved the market rally was misguided, leading to a drop of over 4% in most major US equities on Wednesday. As traders reassess their expectations, this is where the updated projections are going to be so important.
Market expectations
In my mind there was little doubt that the Fed is going to deliver a 75bps hike even before this latest CPI reading, but I think any doubt there may have been has now been thrown out the window. Money markets were pricing in an 88% chance of a 75bps prior to the inflation release on Wednesday, with the remaining 12% still set on 50bps. Since then, markets are pricing in a sure chance that 75bps are delivered on Wednesday next week, with a 35% chance of that hike actually being 100bps.
A good FX pair to trade rate hikes recently has been the dollar against the Japanese yen because of the rate differential. With the Japanese central bank firmly backing its supportive monetary regime, the carry trade against the dollar has become more attractive.
Chart: USD/JPY and its relationship to the US-Japan rate differential
Rate differential between the US and Japan vs the performance of USD/JPY. Photo: capital.com. Source: TradingviewUSD/JPY has managed to slip back in to its recent ascending channel after pushing away from the lower bound at 140.45 last week. So far the bullish momentum has found some resistance at the midpoint of the channel, currently hovering around 145.35, meaning it has been confined to the lower range of the upward channel.
Momentum is still pointing upwards and the moving averages are nicely stacked supporting the bullish case, but the RSI has started to trend below 70 once again, which could potentially lead to a dip below the channel as we saw back at the end of July.
Chart: USD/JPY ascending channel back in play
USD/JPY ascending channel. Photo: capital.com. Source: Tradingview
Will the Bank of England go big this time around?
The Bank of England is facing a slightly different dilemma to the Fed. The latest inflation data has shown a small drop in consumer prices in August, as opposed to the unexpected rise in the US. Headline inflation dropped to 9.9% in August on a year-on-year basis, below estimates of 10.2% and a drop from July’s 10.1%.
There’s no doubt that the immediate reaction from the data gives a sense of false security, with many headlines starting to predict the end of soaring consumer bills. But that is far from the truth, as the month on month figures shows quite clearly that consumer prices continued to rise 0.5% in August. Albeit at a slower pace than expected, the squeeze on consumer spending continues to grow.
Nonetheless, if the August data did provide reason for relief, the US is a great example of how a monthly dip in CPI does not mean the tendency has reverted. August provided another month of price rises despite a small respite in July, something that may very well happen to the UK in the months to come.
The latest reading isn’t sufficient to negate the need for more tightening from the Bank of England, but expectations in the market will have shifted because of a possible top-level view that inflation may have peaked.
Unlike the FED and the ECB, the BOE hasn’t yet worked up the courage to deliver a 75bps hike, opting for more gradual moves to test whether the economy can sustain higher borrowing costs. That isn’t necessarily a bad path to take, but many market participants have deemed this as insufficient to combat inflation, which is seen as the greater of two evils right now. This has had a detrimental effect on the British Pound (GBP), which has dropped over 15% against the US dollar since February this year, when the hiking cycle really took off worldwide.
Markets are slightly leaning towards a 75bps hike at the meeting next week, albeit there is likely to be caution given the BOE’s track record. It wouldn’t be the first time the bank has disappointed the markets by playing it safe, and if we do see 50bps rather than 75bps, the Pound may well face another round of fresh selling against the Dollar.
Nonetheless, it will be a close call heading into the meeting, and this leaves room for disappointment on either side of the Sterling trade. If the BOE does decide to go for the bigger 75bps hike, no doubt analysts will start to consider the detrimental effect on growth, which may see a reversal in optimism in the British Pound in the days after.
That said, GBP/USD is testing the lows from March 2020 after having dipped below it on the 7th of September, which offers a good entry point for new buyers to come in. Beyond this support around 1.1405, the next point of interest is the March 1985 low at 1.0572.
Chart: Daily GBP/USD Chart
GBP/USD. Photo: Capital.com. Source: Tradingview
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