12 July 2022: Brexit and Economy trump Politics

Brexit and Economy trump Politics

12th July: Highlights

  • Bailey admits to mix of risks, but he believes the banking system is solid
  • FOMC members believe that the strengthening economy can handle hikes
  • Growth estimates to be cut again

GBP – Bailey angry about taxes being a political pawn

The UK will have a new Prime Minister on September 5th. The rules of the contest to be the leader of the Conservative Party were revealed last evening. There will be two votes this week and a third if needed will take place next Monday. The deadline for the Parliamentary Party to select the final two Candidates is July 21st which coincides with the Parliamentary Summer recess and a vote of the wider membership will then take place, with the winner announced on 5th September.

There are currently eleven candidates, with a twelfth, Home Secretary Priti Patel, having until later today to declare her candidacy.

The major focus of the early hustings has been taxation with several candidates having announced hope they will lower the tax burden on both businesses and individuals.

The exception to this is former Chancellor and current favourite to win the vote, Rishi Sunak. He has said that he is against an immediate tax cut until inflation is brought under control.

The Bank of England Governor has been critical of the promises being made by leadership candidates, believing that the independence of the Central Bank is threatened by announcing tax cuts at any time other than a formally discussed budget at which the Bank’s input is requested.

Bailey, testifying before the House of Commons Treasury Select Committee, commented that normally financial policy, and fiscal policy which needs to be taken account of, is done in budgets, not as part of a Conservative Party Leadership contest.by an existing Chancellor.

This was a clear, if mild, rebuke to current Chancellor Nadhim Zahawi, who is one of the Leadership Candidates.

Bailey went on to say that he believes that the current risks to the economy are mixed, with both rising inflation and falling output an issue, although it is rising prices that the Bank believes to be the most urgent matter for the MPC.

One UK bank published a report yesterday in which it argued that Brexit and the economy are more important to the country than politics and the next six weeks or so will be little more than a distraction at a very important period in the fight to lower inflation and stimulate the economy.

Yesterday, Sterling was again battered by the relentless rise of the dollar. It fell to a low of 1.1866, closing at 1.1894. It is now well established below 1.20 with commentators expecting the low to be around 1.15 before a significant rally will begin.

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USD – Banks looking ahead but fail to see what’s happening now

Several U.S. banks remain convinced that the U.S. economy is heading for a recession, despite what the more hawkish members of the FOMC are saying about the fight against inflation and the current relative strength of the economy.

The world has become a very different place since it was hit by the global Coronavirus Pandemic. If we look at a deconstruction of the economy with over 350k new jobs being created month after month, there should be no concerns being raised about output but inflation is a by-product of such a strong labour market.

What is happening is that the natural order of these events has become skewed due to other effects such as the energy crisis and the conflict in Ukraine.

As the country emerged from the Pandemic, there should have been a significant rise in GDP as the economy began to return to normal and demand naturally outstripped supply. This issue of supply has been exacerbated by the situation in China, conspiracy theorists would say, is part of China’s global plan.

Rising demand has caused runaway inflation, a factor that has not been present anywhere in the last ten to fifteen years at least.

That has led the Central Bank to act to raise interest rates to quell demand, which has been little more than a natural reaction to two years of lockdowns.

This effect wasn’t spotted anywhere near early enough by the FOMC, with Jerome Powell taking the brunt of the criticism for some ill-timed remarks last summer.

Now, with the Labor market still showing the resilience that marks a strong economy, it is also the source of a significant threat in the shape of inflation.

One of the newer members of the FOMC, Kansas City Fed President Ester George, voted against the seventy-five-basis point increase agreed at the most recent meeting.

She remains a dovish element, speaking yesterday of the Bank’s need to be cautious about balancing hikes against their medium-term effect on output. Her view is that inflation will both fall as the effect on demand is reined in, but also naturally as the rebalancing takes place.

At that point, rates will need to be below the neutral rate, to still offer a degree of stimulation.

Other members of the FOMC see the economy as being sufficiently strong even in the medium-term to stand further hikes, which take the official rate above neutral.

The dollar index continues its journey towards the 1.10 level. Yesterday, it reached a high of 108.26, closing at 108.21.

EUR – Energy crisis barely begun and ECB sees lower inflation

With the ECB not even out often starting blocks in the fight against inflation and the energy crisis in Europe set to worsen considerably, it was announced yesterday that the EU’s gauge of long-term inflation fell back to the 2% level for the first time since March.

It is hard to imagine what model the analysts are using that could come to such a conclusion.

The war in Ukraine shows little or no sign of reaching any conclusion. Ukraine announced only yesterday that it is putting together an army of a million soldiers to take back the south of the country, which has been taken by Russia.

The effect of the food shortage created by the conflict is expected to have a devastating effect on supply.

Furthermore, it was announced yesterday that there is significant uncertainty about whether the Nordstrom one oil pipeline will come back on stream once the rather spurious maintenance that is apparently taking place is complete.

Eurozone finance ministers meeting yesterday have agreed to cut their expectation for growth this year in the Eurozone. They did agree that the fight against inflation must now be the ECB’s primary concern, and a rate hike at the next Governing Council meeting was welcomed.

Commission Vice-President Valdis Dombrovskis forecast lower growth and higher inflation. He went on to say that one can expect downwards revisions, perhaps even more so next year.

Dombrovskis’ comments pre-empted the release of the official data and predictions, which will be released on Thursday.

A sense of realism was provided by Economics Commissioner Paolo Gentiloni, who feared that Russia could very easily cut supplies of gas to the region.

This would see the economy shrink considerably, see inflation rise further and bring higher unemployment.

In May when the last estimates were made, anticipated GDP was cut from 4% to 2.7%, and from 2.7% to2.3% for 2023. It is likely that this year’s growth could be predicted at below 2% and next year to a little below 2%.

The euro may fall below parity this week, particularly if the EU’s estimates are weaker than predicted. Yesterday, it fell to a low of 1.0033 and closed at 1.0041.

There has been little bargain hunting, with the market apparently content to see parity but is in no particular hurry to push it to that level.

Have a great day!
About Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”