European markets have spent most of this week treading water ahead of today’s US CPI inflation report, which could act as a significant bellwether to how much more aggressive the US Federal Reserve is likely to be when it comes to rate hikes. The central bank is currently expected to hike by 75bps at the end of the month.
US markets, on the other hand, have had an altogether softer tone, dropping into the close as worries over slowing growth, and tightening central banks prompted some late weakness. This weakness looks set to manifest itself in a weaker European open, even as Asia markets look set to eke out a positive session.
The decline in the value of sterling in the past few months, particularly against the US dollar, is primarily a direct consequence of a lack of confidence in how the UK economy is likely to perform in the coming months, despite a decent Q1. When combined with a lack of confidence in the reaction function of the Bank of England in dealing with a problem they helped create, is it any wonder the pound is under pressure?
Sterling’s problems have been compounded by the UK government's decision to announce a series of fiscal tightening measures in April, that have served to exacerbate the current squeeze on consumer incomes. Today we’ll get to see further evidence of the damage rising energy prices and tax rates has done to economic activity in May.
The most recent April GDP numbers showed that the UK economy contracted by -0.3%, a much bigger decline than was expected. On the face of it the numbers were very disappointing, however the fall was largely driven by the end of the NHS test and trace programme, as the Covid free testing regime came to an end. Given that this is a one-off effect, and won’t be repeated, the actual numbers, although poor, weren’t as bad as they appear, despite the difficult macro backdrop.
As we look to today’s May numbers, the outlook isn’t likely to improve significantly, even if we see a modest improvement. Fuel prices are set to go even higher with daily reports of record highs for diesel as well as petrol, as it becomes more and more expensive to fill up. At some point this will lead to demand destruction as consumers prioritise spending on essentials.
After the strong US payrolls report on Friday, this week’s price action has been dominated by how much US CPI in June could increase when it is released later today. Ordinarily US CPI numbers aren’t something that would prompt the US central bank to shift on policy, given that its preferred inflation measure is core PCE, which has been in decline since March. The recent May CPI numbers prompted a different reaction, rising sharply to 8.6% and in so doing marking a significant shift in central bank thinking during the Fed’s policymaker blackout period.
The act of anonymously briefing financial markets through friendly journalists that a 75bps rate hike was being actively considered was hugely controversial and remains so, given it raises concerns about the reliability of future guidance expectations. It’s still highly uncertain as to whether the May CPI number was a one-off given that all other inflation measures do appear to show signs of plateauing.
Recent PPI numbers appear to support this mindset, down from 9.6% in March and falling to 8.3% in May. We already have a number of Fed policymakers arguing for another 75bps rate hike at the July meeting. Expectations for this week’s June CPI number is for a rise to 8.8%, and a new 40-year peak, which flies in the direction of travel when it comes to recent prices paid numbers, and the slowdowns being seen in PPI and core PCE, which have been trending lower since March.
There is an element of two-way risk in today’s numbers. If US CPI suddenly slips back in June, it won’t weaken the case for a 75bps move in July, but it might weaken the case for a 75bps in September. Of course, we could see an upside surprise if companies suddenly start raising prices on services, as they bite the bullet on passing rising costs on to consumers. There is the distinct possibility we could see a move above 9%, which would have investors scrambling to price in a potential rate move of 100bps at the end of this month.
Whatever happens today, the Bank of Canada has the opportunity to start getting ahead of the Federal Reserve by hiking rates by 75bps today. At its last rate meeting the Bank of Canada raised interest rates by 50bps, which was in line with expectations, however the statement suggested more aggressive hikes were likely, due to the risks of elevated CPI becoming entrenched.
CPI in Canada has already risen to 7.7% in May, jumping sharply from 6.8% in April. The risks of elevated CPI “has risen”, which suggests that the Bank of Canada will act again with another big rise of 75bps, pushing the headline rate to 2.25%, given that the Fed will be hiking by 75bps at the end of this month.
EUR/USD – kissed parity yesterday, making another 19-year low, before a short covering rally pulled it off the lows. We still have potential for a move towards 0.9660 but could squeeze back to 1.0200 first. We need to see a move back above 1.0340/50 to stabilise and delay the prospect of further weakness.
GBP/USD – a marginal new low yesterday, just above 1.1800 has seen the pound continue to drift lower with the 1.1500 area the next key support level. We need to see a move back above the 1.2040/50 area and the 50-day SMA to stabilise and target the 1.2120 area.
EUR/GBP – still holding above the 100- and 200-day SMA at 0.8440/50 after posting its biggest weekly fall this year last week. The risk remains for further losses towards 0.8380, while below resistance which comes in at the 0.8520/30 area.
USD/JPY – has slipped back below the 137.00 area after peaking at 137.75 and looks on course for a move towards the 140.00 level. Currently has solid support at the 134.80 area.