15 August 2022: Bailey demands continued freedom

Bailey demands continued freedom

15th August: Highlights

  • UK economy contracts in Q2
  • Employers still struggling to find suitable workers
  • ECB action in line with policy restructure

GBP – Independent Bank of England best to maintain economy

As expected, the UK economy contracted in the period between April and June, but by less than had been expected.

GDP was 0.1% lower than in the previous quarter, leading to a year-on-year increase of 2.9% following an 8.9% rise previously.

Data for professionals’ services showed a significant increase, with both the accountancy and legal sectors reporting increases in turnover as revenues swelled.

Since Andrew Bailey confirmed the Bank of England’s view that the economy was going to head into a technical recession, it will not be a surprise if the figures for the current quarter are worse.

With the Bank of England unlikely to follow the Federal Reserve in denying that the economy is contracting, it will begin to face pressure to add support, particularly with headline inflation expected to fall this month given the current price of petrol.

The current energy crisis and wider cost of living concerns has become the focus of politicians from both sides of the House of Commons.

The Leader of the Opposition, Sir Keir Starmer, has called for a windfall tax on energy companies which have announced record profits and the cancellation of the proposed increase in the energy cap which is due to be levied in October.

This subject has also been exercising the candidates for the Leadership of the Conservative Party.

Liz Truss has already said she is against a windfall tax as it sends the wrong message to potential investors that the country penalizes successful businesses, while Rishi Sunak has already initiated such a move when he was Chancellor earlier this year.

Andrew Bailey has also come out strongly defending the independence of the Bank of England. If the Central Bank were to be brought back under the control of the Treasury, reversing a decision that was made twenty-five years ago, it would not only affect its ability to control monetary policy, but would also make it more difficult for it to perform its regulatory role.

Since 1997, the amount of lobbying of MPs over the BoE’s control of the City of London has dwindled and given foreign investors more confidence, Bailey believes.

The market remains cautious about making any significant bets on the direction of Sterling. Versus the euro it remains between 1.15 and 1.20, while against the dollar, buyers emerge around 1.18, but there are large sell orders on any approach to 1.2280.

Last week the pound rallied to a high of 1.2276 but fell back to close at 1.2137.

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USD – Can FOMC maintain its hawkish stance?

Over the past few months, the FOMC has allowed itself to become a little predictable as it has only varied the size of its rate hikes, while maintaining the direction of monetary policy.

In the minutes of its latest meeting, which will be published this Wednesday, traders are likely to be kept guessing whether it feels that the danger of tipping the economy even further into recession by agreeing on another seventy-five-basis point hike.

Early on in this tightening cycle, members of the FOMC, when challenged about what they believe to be the neutral rate, commented, on average, that it was around 2.25% to 2.50%.

That is where the Fed Funds rate is currently, so traders are naturally inquisitive whether the feeling is the same, especially since inflation continues to rise despite last week’s slight fall in the headline number for July.

The series of rate hikes that have been seen over the past few months, which have been gradually increasing in size, are designed to dampen down demand to slow inflation. However, since a large part of the rise in prices has been in no small part due to issues of supply, they have been only partially successful.

Rising inflation is a global issue currently. It began when China, as manufacturing was restarted following the Pandemic, although that is only part of the story since output continues to be affected by pockets of infection.

The war in Ukraine and the Russian reaction of sanctions has seen prices increase. While the U.S. is close to being gas self-sufficient, rising prices, particularly of gasoline, have also seen headline inflation increase.

The data for July which was published last week saw core inflation remain unchanged at 5.9% in July. This will be something that the FOMC will have taken note of, but they will have the benefit of knowing the rate for August before they meet again on 20/21 September.

Given the larger than usual gap between meetings, the minutes of the last meeting, held six weeks ago, the FOMC may have discussed the possibility of being able to slow the rate of increase in the Fed Funds rate, but is unlikely to provide any further advance guidance.

It is likely that FOMC members speaking over the next few weeks will be asked to give their view on both the chances of a genuine recession, and the prospects for interest rates. Their responses will provide the marker with a degree of impetus as it emerges from the summer lull.

This week will see the release of data for both the housing market and retail sales. These are both significant indicators of any further contraction in the economy.

Last week, the dollar suffered marginally as risk appetite began to improve. The index fell to a low of 104.63 following the weaker than expected inflation figures. but recovered to close at 105.67.

EUR – Fading supply chain issues give a boost to production

Prior to the second significant heat wave of the summer, fractured supply chains across Europe were beginning to recover. This led to an improvement in industrial and manufacturing production.

However, the falling water levels in several of the continent’s major rivers like the Rhine, Danube and even the Dnipro in Ukraine have seen supply chains hit again.

The economy of the Eurozone therefore continues to feel the heat in every direction. Inflation continues to rise, exacerbated by the continued reduction with the supply of gas from Russia, which is creating significant issues for German heavy industry.

It was announced recently that if supplies do not improve as Autumn and Winter set in, the German Government may be left with a difficult choice whether to supply gas to heat homes or continue to keep factories running.

The recent improvement in supplies of certain raw materials means that the region is getting close to having caught up with the backlog of orders that came as the Pandemic receded.

However, this means that the rate of the slowdown in demand will become ever more evident. The increase in rates that was approved at the most recent ECB meeting is likely to be repeated at the next such meeting, and this will dampen demand even further.

With France, Germany, Italy, and the EU itself being members of the informal group. Including Japan, Canada, the US and UK, it actually has eight members. Prior to its invasion of Ukraine, Russia was also invited to meetings.

ECB President, Christine Lagarde, spoke last week of her surprise at how the financial markets had viewed the Central Bank’s decision to hike interest rates at its most recent meeting.

She said that the decision to tighten policy as and when necessary was taken last summer at the time of the full strategic review of the Bank’s policies. If anything, this highlights more clearly the disagreement that was raging through the Spring, since that was when inflation really began to take off.

Germany was against the change in the Bank’s inflation target when the absolute 2% target was changed to an average of 2%. This allowed inflation to rise significantly above the previous 2% target before the ECB was obliged to act.

Since it was still providing support to weaker economies, still recovering from the Pandemic, inflation was allowed to rise unchecked.

The most common view within the market is that the euro will eventually fall below parity with the dollar and this time remain there for some time. Last week, it managed to claw its way to a high of 1.0368. Based on dollar weakness following the inflation report but was unable to gain any momentum and fell back to close at 1.0260.

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.”