- Economy to decline by 1.3% in 2023
- No chance of a rate cut in 2023
- Recession fears ease, but debt is a major problem
City traders have rules for a very good reason
Inflation, political turmoil and strikes have been at the centre, while a downturn of economy and rising interest rates have been the predictable outcome.
After more than a decade when the Bank of England’s independence was barely tested, this year there have been nine interest rate hikes as the performance of the Central Bank has been under scrutiny.
Brexit has not provided businesses with the level of freedom that was expected. The Bank of England has expressed concern about the intended deregulation of the City of London, in particular the ring fencing of bank’s commercial and investment banking operations.
The restrictions were put in place to ensure that riskier investment banking operations were funded by capital and not customer funds. Now, in order to promote the City as a centre for innovation in a post-Brexit environment, the Government is seriously considering removal of the regulation, allowing the blurring of the edges of what is investment and what are commercial operations.
The downturn in the economy won’t lead to the Bank supporting the economy, at least not in the short-term, as inflation continues to rise.
The current energy crisis, the war in Ukraine and the aftermath of the pandemic are each contributing to the rise in prices and the tightening of monetary policy at a time when the economy is beginning to show signs of stagflation is the only policy option left to the Bank of England.
The strikes that are being seen currently in several sectors of the economy are contributing to a concern that a wage price spiral is created where inflation busting pay awards are delivered which simply adds to further inflation fears which leads to further pay claims and so on indefinitely.
This is one reason why the Government is remaining tough on the size of pay awards to nurses, ambulance crews, train drivers, and a number of other public sector workers.
The financial markets have moved into holiday mode this week and Sterling has begun to drift. Yesterday it fell marginally, reaching a low of 1.2120 and closing at 1.2143.
Make instant international transfers
Transfer money immediately to another currency
Outlook is recession-ish but no contraction is expected
While there has been no particular effort made by the Central Bank to provide that support, in fact by tightening monetary policy they have, if anything, exacerbated the situation. The current view is that a recession is around 30% likely to take place.
One reason that a recession is considered unlikely is the current strength of the employment market which, on the face of it, is defying all predictions of severe job losses in the new year.
There was a particularly bearish prediction made by a number of economists, in which they believed that headline new jobs data would be negative by the end of the first quarter. Of course, such a turnaround could still occur, but it would need an event of seismic proportions for jobs creation to fall off a cliff in such a manner.
The main reason that the economy has not been significantly affected by the FOMC aggressively hiking short-term interest rates is that they had been incredibly accommodative for many years and despite seeing hikes of up to seventy-five basis points at consecutive meetings, rates have only just become restrictive.
The mood of the market is now accepting of the fact that only now employment will see the moderate fall that the Bank is trying to promote.
The December report, which will be published on January 6th, is expected to see a downturn in the headline number but remain well into positive territory.
This will lead to the Fed being able to react to falling inflation by beginning to taper its rate increases.
Meanwhile, other leading indicators of economic activity are holding up well, which is adding to the feeling that a recession would be an anomaly despite a marginal slowdown in overall activity.
The dollar also drifted yesterday. It rose to a high of 104.42, but lacked any momentum and fell back to close at 104.66 as it bumped along at the bottom of its recent range.
Anti-EU policies being considered, but not an Italexit
The new cap is about 30% lower than the current one, and will provide a significant cushion to the impact of the energy crisis.
Given that the hawks just about won out at the most recent meeting of the ECB’s Rate Setting Governing Council, this will be seen as a victory for common sense and will provide a degree of support for economies that are struggling.
Rising prices have cost the EU around a trillion euros already and with instability expected to last until at least 2026. The additional costs are unlikely to see the economy return to growth before then.
Economic data releases are still adding to the confusion being seen by the market. Rear-view mirror indicators continue to show that the economy isn’t suffering as much as was predicted, while leading indicators paint a confusing picture.
The averages that are used by the bureau of statistics do not do justice to the few economies that are weathering the storm well, but due to the fact that the largest economies in the region are suffering, the numbers may be skewed.
It would be truly remarkable if the entire Eurozone escapes from a recession despite the ECB offering little support. As in the U.S. rates have not yet reached the point where they are restricting demand despite the fact that inflation looks to have topped out.
The pace of any fall in inflation will determine when the ECB is able to taper the cycle of interest rates increases.
That day cannot come soon enough for Italian politicians who en-bloc have been critical of the latest rate increases which have been labelled absurd, incredible and unbelievable among other less savoury names.
Italy is facing a severe debt crisis. Not only are its people suffering from higher short-term rates, but the reduction in the level of support from the ECB is forcing it to pay far higher rates on its government bonds without the implicit guarantee of the EU.
The euro has joined the market’s holiday doldrums. It rallied to a high of 1.0658 yesterday, but quickly ran out of steam and closed at 1.0604.
Have a great day!
Exchange rate movements:
19 Dec - 20 Dec 2022
Click on a currency pair to set up a rate alert
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.