City sees 100% certainty of rate hike
1st February: Highlights
- Brexit is the real villain
- Economy is growing by fastest rate since the 1980’s
- Economy grows but hard to notice
Investors not so sure
The hike is now 100 priced into the interest rate markets. This is an increase on last week when the expectation of an increase was 90%.
With inflation at its highest level since 1992 traders are experiencing historic events that are outside the experience of many.
Inflation is currently closing in on 6%. The latest official data put the headline rate at 5.4%, but prices are clearly continuing to rise at a rapid rate. The employment market is also booming with the unemployment rate 4.1% which is close to historic lows.
Speculation is growing about what official rates will be at the end of the year. It is possible that they could have risen as high as 1.75%, but most see a rate of 1.25% at year-end.
There is growing criticism of the Bank and in particular its Governor Andrew Bailey over how the economy was portrayed through the second half of last year.
While it would have been hard to justify tighter monetary policy given the way the economy was performing, verbal intervention and an acknowledgement of the fact that policies put in place to provide support could have led to inflation down the road would have provided markets with a sense of realism.
Now given the dip in growth that is likely to follow the factors that will play a part going forward, the Central bank is being forced to hike, against the will of some members of the MPC. The vote at Thursday’s meeting will be an interesting factor going forward. There are members who are ingrained hawks or doves, but those who are swayed by the current situation could be hard to predict.
On balance, it is highly likely that the second hike of this cycle will occur this week, but there remains a slim chance that some forward-thinking may prevail.
Yesterday, the pound recovered from the mauling it received late last week from a rampant dollar. It climbed to 1.3460 and closed at 1.3449.
But it’s inflation that needs tackling
It may take some time for the Fed’s tightening of monetary policy takes full effect and there is a degree of speculation that the FOMC will begin the cycle with a 50bp hike next month.
While a hike of such magnitude will be an unusual step to the current market, such moves were commonplace the last time inflation was this high, and while the term normalization is being mentioned, moving from a Fed Funds rate of 0.25% to 0.75% in one go is certainly anything but normal.
Looking back through the lens of hindsight, history will say that removal of support should have begun a month, two months earlier.
Jerome Powell was put in a difficult position, gauging market influences. He has all but admitted that he got it wrong when describing inflation as transitory, but it is 100% certain no analyst or commentator would have agreed that on the 1st of February inflation would be 7%.
Now the FOMC is 100% committed to fighting inflation, but the balance of risks turned from growth to inflation remarkably quickly, due to difficulties in the supply side of the economy.
Wage rises are beginning to increase, and the Fed will be concerned about a wages/inflation spiral beginning in which workers look at 7% inflation, which may indeed be a transitory rate and base their claims upon that.
Prices have risen at an unprecedented rate over the past 9 months or so, and while it is unlikely that inflation will be brought back under control as quickly, the Fed is likely to call for moderation in an employment market that is already tight.
The rise in the value of the dollar last week may have been a little extreme, but it illustrated two things, first potent up demand for dollars still exists, and the markets expectations over economies that remain dovish compared to those prepared to tighten policy is clear.
Yesterday, the dollar corrected some of its rise from last week. The index fell to a low of 96.52, closing at 92.64,
The dollar’s correction coincided with a fall in market expectations for headline non-farm payrolls that are due for release on Friday, the mean expectation now is for 165k new jobs to have been created in January.
Hawks demanding a rate hike
Lagarde was quoted as saying that the ECB has several reasons not to act as quickly or ruthlessly as the Federal Reserve. That opinion is sure to be challenged by many of her colleagues on the Governing Council when it convenes later this week.
Lagarde has had a number of weeks in which to formulate both her opinion and her defence of her current position.
With the current round of support ending next month, there will be pressure to start to move towards a more normal set of monetary policies, but she will want to maintain a degree of support until the end of the second quarter at least.
With inflation likely to begin to fall from April onwards, the Central Bank will be correct to withdraw support gradually so as not to interfere too radically with the operation of the government bond markets.
Furthermore, once the withdrawal begins, the ECB will be faced with the dilemma of its holdings of bonds and the effect of no longer being the most available purchaser of government debt.
The ECB President is an advocate of the fact that inflation will begin to fall gradually from April and expected it to be close to target by the end of the year.
It is odd for Lagarde to admit that the recovery in the U.S. is well ahead of the Eurozone without offering any reason as to why she believes that to be true.
In fact, it is probably due in part to the reaction on the mainland to the rise in the Omicron Variant, but it was evident, as mentioned above, long before that. The use of more targeted relief in the U.S. while the ECB chose to be more general has probably been a more significant and long-lasting reason.
The euro regained a little composure yesterday as it almost regained the 1.1250 level.
It rose to 1.1248 and closed at 1.1235.
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.”