Ebury: Focus on central banks and interest rates

By Enrique Diaz – Alvarez

A peak in US inflation has been expected for some time now, but has yet to materialise, and June was no exception. The nasty surprise in inflation rates sent the dollar broadly higher, but the euro strongly defended the psychologically important parity level and after briefly breaking it, managed to finish the week above it. Markets are now pricing in some possibility of a near-unprecedented 100 basis point hike at the next Federal Reserve meeting, and in that context it is somewhat reassuring that risk assets such as stocks and emerging market currencies managed to finish the week flat to slightly lower .

All eyes now turn to the European Central Bank meeting on Thursday. With a 25 basis point hike priced in and markets giving a 10% chance of a 50 basis point surprise, there will be room for an appreciation should the ECB decide to shake up the markets. The Bank of Japan is also meeting, and is expected to remain the exception to the current trend of monetary policy change, supporting the extreme accommodation it had adopted before inflation. UK inflation will be released on Tuesday, while July’s headline PMIs in most major economies will round off an extremely busy week.

Sterling

Solid economic data for May released last week in the UK did little to help sterling, which fell against every G10 rival last week except the Japanese yen. Wednesday’s CPI data is likely to hit another multi-decade record, which along with the recent dovishness we’ve seen in speeches from Bank of England policymakers would validate our expectation of a 50-point double-digit increase base in August. This week’s labor market report will also show us whether indirect inflationary effects are becoming apparent in the wage-setting process. Business PMIs will close out this extremely busy week, and are all expected to remain comfortably at expansion levels.

Euro

Last week there was mixed news from the Eurozone economy, with a sharp contraction in car registrations but also a positive surprise in May industrial production. Markets have completely ignored these minor reports, and are focusing on two key events. In addition to Thursday’s European Central Bank meeting, the Nordstream natural gas pipeline is scheduled to restart natural gas deliveries on the same day, which could cause some volatility in trading. The market has discounted a 25 basis point hike, which would open a window for the European Central Bank to surprise markets and begin to restore its inflation-fighting credibility. But perhaps more important than the actual policy move will be the level of consensus reached around the financial fragmentation tool which is a euphemism for restarting the weak regional bond market using freshly printed euros. This week is expected to be one of the most intense trading weeks in recent (many) months for the common currency.

US dollar

Hopes that US inflation has peaked following last month’s Personal Consumption Expenditure (PCE) report were dashed by another nasty surprise in June’s Consumer Price Index report. However, we believe that hikes of more than 75 basis points are unlikely to be announced, and that markets are rushing to price that possibility, as well as that the dollar’s rally becomes vulnerable to a correction of these expectations. This week the dollar will cede the spotlight to other currencies and particularly the euro as only minor data is released. This time, the dollar will be affected by developments happening elsewhere.

* Enrique Diaz – Alvarez is Chief Risk Officer of the international payments company Ebury