13 September 2022: Period of mourning threatens growth

Period of mourning threatens growth

13th September: Highlights

  • Economy grew in July, but is still likely to have contract in Q3
  • Possible railroad strike labelled a national disaster
  • OECD warns about weakening economy in Q3

GBP – GDP expansion on a knife edge but BoE will still hike

The economy grew in July according to figures released yesterday but is still seen as contracting overall in the third quarter.

The period of mourning, whether official or unofficial, will almost certainly mean that there will be contraction this month and there is nothing to suggest that August was anything other than average.

The Bank of England believes the economy will fall into a technical recession, where there are two consecutive quarters of contraction, or negative growth as economists prefer to call it. This will be followed by an ever-increasing slowdown that will last for the whole of next year.

The country will truly experience stagflation as a recession will be coupled by a level of inflation which is already considerable but will become significantly worse. There is likely to be large scale industrial action as the workforce demand wage increases that are keeping pace with rising inflation but employers struggling to keep costs down as the recession starts to bite will be unable to comply.

Liz Truss has been rather overtaken by events during her first week as Prime Minister. She has been forced to abandon her desire to hit the ground running, although she has found the time to provide support to help with the cost-of-living cruises.

The average household will have its energy bill capped at around £2,500 a year for the next two years beginning next month. This will have brought a collective sigh of relief from the public who were looking at a significantly higher rate from next month with further increases next January and probably April.

The employment report for August is due to be released this morning. It is expected to continue the gradual fall in the number of people claiming unemployment benefit, but it is the wages part of the data that will attract the most attention. Wages, without bonuses included, will have risen by more than 5%.

This is expected to mark the beginning of the wages/prices spiral where workers demand ever higher salaries, which drives up their employer’s costs, which drives up inflation, which in turn drives demand for ever higher wages.

Then, tomorrow, the latest figures on inflation will be released. Observers will be interested in both the headline figure as well as the core with volatile items like energy and food stripped out, but also the rate of growth. This is expected to have slowed in August but is predicted to pick up later in the year. The prediction is for headline inflation to have risen to 10.2% just 0.1% higher than in July.

The pound recovered further ground against a correcting dollar. It reached 1.1710, closing at 1.1686. It needs to clear resistance at 1.1740 to see more significant improvement.

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USD – Dynamics alter as economy goes into restrictive policy

A report released yesterday accused the Federal Reserve of deliberately targeting job losses to bring down inflation. While this is unlikely to be the main reason rates are being increased, there is little doubt that it is an unfortunate by-product of the policy.

It is widely believed that the fed funds rate is at, or at least close to, the neutral rate where it neither stimulates nor restricts growth. There is no fixed level where this happens, and it will only be understood with hindsight.

The next rate hike, which will take place at the FOMC meeting on 21st September, will therefore confirm that monetary policy is officially restrictive.

This will see a change in the dynamic where interest costs drive up prices and therefore inflation. It will likely see businesses, particularly SMEs, consider reducing costs and, for many, far and away their most significant cost is labour.

This means that we may have already seen the low for the employment rotate, or if not, it will be seen very soon.

We will then see the Fed taper the rate at which it hikes interest rates.

There is a growth belief in the financial markets that despite several hikes in rates since the Spring, inflation is continuing to rise due to the amount of money that is in the system.

The Fed announced that it would shrink its balance sheet. gradually over a period of several months, but there are calls for the pace of that shrinkage to be increased.

The most obvious effect of the amount of money that is sloshing around the system is the fact that equity markets continue to do well, and it is the same new age stocks like Amazon, Apple, Netflix, and Tesla that continue to drive markets.

As rates turn restrictive, those stocks and a few others like them may see a significant correction, despite the company’s assertion that they are future-proof.

The latest inflation report will be published later today. and it is expected that the headline will have fallen from 8.5 in July to 8.1% in August. While this may be due to seasonal factors, it will nonetheless be welcomed despite that fact it is unlikely to have any bearing on the FOMC.

The dollar index is experiencing a deeper correction driven by investors who were long of the Greenback in anticipation that a break of the 110 level would reap further gains.

It fell to a low of 107.80 but recovered due to a little bargain hunting to close at 108.30.

EUR – ECB action far from welcomed in weaker economies

The first effect of the record rate hike last week from the ECB was entirely predictable. The Central Banks and Finance Ministries of the weaker economies began complaining that the hike would drive their economies into a recession.

They conveniently failed to acknowledge that their policies particularly with regard, in several cases, to public spending, particularly when they could borrow almost unlimited sums from the ECB at highly competitive rates, would have driven their economies close to the brink in any event.

This is a nutshell is why one size does not fit all and will remain a recurring theme until there is a major overhaul of the way the European Union works financially.

There is possibly another major shock just around the corner for the EU, with the General election in Italy taking place a week from Sunday. If Five Star gain a majority, which is widely expected, talk there will inevitably turn towards the benefits of continued membership of the European Union.

Mario Draghi, the former President of the European Central Bank, returned home a couple of years ago and was promptly elected Prime Minister of a Government of National Unity.

However, Italy doesn’t really do national unity and the population quickly grew disaffected by his moderate brand of politics, which allowed for the return of the right-wing nationalists.

Italy has long been the bête noir of the Eurozone, and the election certainly won’t bring any sort of unity.

Naturally, the Governor of the Bank of Italy, Ignazio Visco, who followed Draghi when he left for Frankfurt, has been one of the most vociferous critics of the ECB.

He believes that far from raising interest rates, the Central bank should have continued pumping money into the system.

He feels that Germany has limited itself by insisting on its own form of financial discipline, which has not allowed the entire region to recover from the Pandemic.

Inflation was a natural side effect of the support that was provided during the Pandemic and doesn’t understand the undue haste with which the support has been withdrawn.

The euro rally is solely due to dollar weakness, and there are investors lining up to renew short positions at the first sign of dollar strength.

Yesterday, the single currency rallied to a high of 1.0190, but it found the air a little too rarefied that high and fell back to close at 1.0122.

Have a great day!

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.