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Fed hikes rates despite weak inflation outlook

It was a rather mixed day for stock markets yesterday, with the Dow making another new record close, while the Nasdaq and S&P 500 slipped back after the US Federal Reserve raised rates as expected, by 0.25%.

Energy stocks were the main laggard after crude oil prices slid back again after a surprise build in gasoline stockpiles, and rising expectations that non-OPEC oil production will negate OPEC’s output cuts. The rise in gasoline stockpiles suggests a lack of demand, somewhat surprising given that we are in the midst of US driving season.

Having spent most of the last six weeks preparing the market for yesterday’s rate rise, the US Federal Reserve would have been unwise to demur at this late stage; however yesterday’s weak inflation numbers, coming on the back of a weak first-quarter are likely to be a cause for concern. If there was concern it would appear that policymakers are determined not to show it, confident that the current weakness is transitory in nature, and keeping their options open for one more rate hike this year.

US dollar sinks

The US dollar sank in the aftermath of yesterday’s disappointing inflation and retail sales numbers, in anticipation that the Fed would be slightly more dovish in its outlook for the US economy. That they were not was a little surprising, though they did revise down their core inflation forecast for this year to 1.7%, while also reducing their unemployment forecast to 4 3% for this year and 4.2% in 2018 and 2019.

Instead, policymakers fleshed out further detail on the central bank’s balance sheet reduction programme, which Janet Yellen suggested could start in September if the data warranted it. It's a very big 'if' at this point, starting with a $6bn cap a month on treasuries and a $4bn cap a month on mortgage-backed securities.

The Fed's confidence that inflation will return to target is based on a tightening jobs market, and some skills shortages in high-value jobs, however with so little evidence of rising wages or prices, there is a growing concern that far from being behind the curve they are tightening too quickly, in the face of some worrying warning signs of a slowing economy.

UK retail sales set to slump

In the UK, the slowdown in consumer spending won't have been helped by the latest average earnings data for April which saw wages rise by only 1.7%, well below the inflation rate of 2.7% for that month. That we saw a strong retail sales number in April of 2.3% is quite remarkable, which suggests that we probably won’t see a decent number in this morning’s May data, particularly since CPI in May jumped to 2.9%, further widening the gap between prices and wages in the wrong direction.

The last two quarters' retail sales numbers have been a negative contributor to GDP and unless wages start to pick up and keep track of the rise in prices, then it is unlikely that we’ll get to see a recovery in spending soon, though input prices would appear to suggest that inflationary pressures may be plateauing in the short term. The sharp rise in inflation doesn’t bode well for today’s May retail sales, with predictions that we could well see a sharp drop of -1%.

Against this backdrop it is hard to see any other outcome than for the Bank of England to leave interest rates unchanged, particularly at a time when the political backdrop is so uncertain. It is this uncertainty that may well act as an added factor in the central bank's deliberations and might well prompt outgoing MPC member and hawk Kristin Forbes to change her vote to a hold in light of recent events, though it does seem unlikely.

Forex snapshot

EUR/USD – yesterday’s failure to push through the November highs at 1.1300 keeps the current range intact and as such raises the prospect of a move back to the 1.1170 level. A break below the 1.1150 area could well see a move back to the 1.1020 area.

GBP/USD – the pound topped out at the 1.2820 level and 50 day MA yesterday. It currently remains corralled between this resistance area and support just above the 100 and 200 day MA’s as well as the 1.2635 area. A move through 1.2830 argues for a retest of the 1.2920 area.

EUR/GBP – the failure to push through the 0.8860/70 area this week raises the prospect of a move back to the 0.8720 area in the short term. A move through the 0.8860/70 area argues for a possible move towards the 0.8920 area.

USD/JPY – we dropped back to the 108.80 area yesterday before rebounding, but we need to push back above the 200 day MA at 110.60 to stabilise and argue for a move higher. While below this week’s high the risk remains towards the downside and a return to the 108.00 area.

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