Dovish UK hikes
Prices have risen sharply in Britain and around the world over the past 12 months as demand has soared, and supply chain problems caused by the pandemic have disrupted global trade.
Sterling has had a bad March. In terms of developed market currencies, it has only outperformed the yen, which plummeted during the month.
The pound has also struggled against the commodity currencies as concerns about the situation in Ukraine have driven up commodity prices. In addition, GBP/USD has declined amid the juxtaposition between an increasingly hawkish Fed and a more cautious Bank of England (BoE). The outlook for fewer than expected BoE rate hikes in 2022 could limit/slow future pound gains.
In March the Bank of England increased Bank Base Rate by 25bp to 0.75%. This was the third consecutive increase in the official central bank rate and takes us back to levels last seen in August 2018. The vote was split 8-1 (one member preferred to maintain Bank Rate at 0.5%).
Inflation (CPI) currently sits at 6.2%, versus a target of 2%, with the outlook that inflation will continue to spiral, even talk of double digits in RPI, especially in light of changes in commodity, fuel and energy price impacts, as well as the energy prices cap being lifted on the 1stApril.
The Monetary Policy Committee are watching the invasion of Ukraine by Russia and are highly conscious of the impact the situation could have. With global inflationary pressures likely to strengthen considerably over coming months, net energy importers, such as the United Kingdom, are likely to see greater impact.
Importantly the Monetary Policy Committee (MPC) minutes noted ‘based on its current assessment of the economic situation, the Committee judges that some further modest tightening in monetary policy may be appropriate in the coming months, but there are risks on both sides of that judgement depending on how medium-term prospects for inflation evolve.’
The change in tone to ‘modest’ is key here and fits with our view that the MPC will pause at 1% to digest the impact of their actions. A repricing of rate expectations is unlikely to be positive for the pound.
The last meeting for the MPC was on 5 May 2022.
On a side note, COVID-19 resurgence in China, has seen Shanghai take action this week by splitting the city into two and alternating a mass lockdown between the areas. The eastern side of the city will be under restrictions from 28 March until 1 April, and the western side from 1-5 April. This is likely to impact goods, services and real demand for commodities.
The Federal Reserve (FED) in hawkish mood
As expected, the Fed hiked rates by 25bp in March, taking the Fed funds target range to 0.25-0.50%. Its rhetoric remained on the hawkish side, signalling more concern about rising inflation than risks to growth.
However, the 2022 Gross domestic product (GDP) forecast was cut to 2.8% from 4%, slowing further to 2.3% in 2023 and 1.9% in 2024. Meanwhile, inflation is now forecast at 4.3% this year from 2.6% previously but slowing to 2.7% in 2023 and 2.3% in 2024.
Consequently, in line with the market and the Fed’s dot plot, we expect a 25bp rate hike at every remaining Fed meeting this year. Indeed, if inflation risks increase (CPI was 7.9% YoY in February), the Federal Open Market Committee (FOMC) could decide to move by 50bp. Chair Powell conceded as much on 21 March. His comments did boost the USD but the gains faded, which again highlights to us that the current level of Fed hawkishness is baked into the already strong USD and the market will need to be ‘fed’ a more hawkish stance to pull the currency significantly higher.
As we move towards Q2-22, global sentiment remains precarious, making the USD susceptible to rallying on safe-haven demand. But since equities hit market lows and oil hit new highs on 7th March, sentiment has been more stable even if risk appetite remains low.
Note, that the commodity currencies; AUD, NZD, NOK and CAD, have been the best performing currencies year-to-date, slowing the USD’s advance.
European Central Bank (ECB) to act later this year
The ECB was less dovish than expected in March and remains on course to end net asset purchases and could hike rates by year-end, although with other banks adopting a more hawkish stance, the euro may still struggle to significantly strengthen in coming months.
Two factors remain key to near-term euro dynamics. First, the outlook for monetary policy and the effect on yields. Second, swings in risk appetite, their impact on demand for safe-haven and commodity currencies and the spill-over to euro positioning. These factors have kept the euro under pressure in March, with it underperforming all of its peers except the yen as equities picked up post 7 March and as higher US yields pulled USD/JPY up.
The forecast for 2022 GDP growth was cut to 3.7% from 4.2%, possibly slowing to 2.3% in a worst-case scenario. However, CPI this year was revised up to 5.1% from 3.2%, with a risk that it could be as high as 7.1%. Therefore, the ECB is sticking to its roadmap to withdraw stimulus, with net asset purchases likely to end in Q3-22 and a rate hike likely by the end of the year, in line with comments from some ECB officials. Admittedly, the tightening of policy remains data-dependent, with President Lagarde retaining a degree of flexibility and optionality.
However, in relative terms the ECB’s policy stance has offered less euro support given the expectation that other central banks will hike rates more quickly. Hence, the current policy divergence and yield spreads remain a drag on the euro.
Further, whilst weak risk appetite and geopolitical concerns will remain a downside risk to the euro, or rather USD positive, at the time of writing sentiment and equity markets, although still low, have recovered.
Looking forward it is worth noting that the French presidential elections are due to take place over two votes, on 10 and 24 April. Political uncertainty would normally be seen as euro negative, but given wider geopolitical events, for now the market has shrugged off the upcoming event.
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