21 April 2022: Sterling’s fate rests in divergence

Sterling’s fate rests in divergence

21st April: Highlights

  • Bank of England to create British rules post-Brexit
  • U.S. joins the ranks of major oil exporters
  • ECB Officials see first hike in Q3

Dovish BoE to drag Sterling lower

The medium term fate for Sterling lies in the hands of the Bank of England and its plans to lower the level of inflation, which is currently running at 7%, up from 6.1% a month ago.

The Bank faces a tricky balancing act as it endeavours to tighten monetary policy to drive inflation lower, but remains aware that the economy remains fragile and could easily be tipped into recession if the tightening is too aggressive.

With energy prices having risen as the price cap was raised at the beginning of the month. Gas and electricity prices to domestic users have been the most significant contributor to inflation over the past month.

Yesterday, the six principal energy suppliers called upon the Government to provide some relief to consumers. They called for the energy cap to be abolished in favour of a simpler and fairer system in order to avoid a horrific situation next winter when it is expected that the cap will be raised again.

The Parliamentary Business, Energy and Industrial Committee was told that scrapping the current cap in favour of a more social arrangement would help the lower paid while the better off would pay more.

The CEO of Scottish Power, speaking on behalf of his colleagues in the industry, told MPs that the situation had become so serious that it was now too big for his firm to deal with alone and is becoming too big for the entire industry and called for the Government to step in and take responsibility.

The conflict in Ukraine is clearly having an effect on energy prices, although demand from China was also a significant factor, but the rise of Covid lockdowns around Beijing has dampened their need in the short term.

The Bank of England’s Monetary Policy Committee next meets on May 5th and to echo the words of the energy sector, a decision on interest rates may be becoming too big for nine individuals with academic motives for their decision-making to be allowed to decide.

Given the more hawkish comments being made by Central bankers in the U.S. it is now almost certain that the gap between monetary policy there and in the UK is set to widen, and this will see the pound weaken.

Yesterday, the pound rose to a high of 1.3068 and closed at 1.3042. Rallies are now being seen as selling opportunities, with resistance at 1.3080 looking solid.

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Neutral rate seen at 2.5%, at least

As already mentioned above, Federal Reserve Officials are appearing to become far more hawkish in their intentions towards fighting inflation.

They clearly believe that the economy is now in a sufficiently strong position for them to concentrate solely on bringing down rising prices.

The country has always been extremely sensitive to rising energy prices. This was demonstrated in the 1970s, as the price of a gallon of gas (petrol) rising above a dollar for the first time almost caused riots.

At that time, the Administration put in place measures that are designed to help consumers, and they are still in effect today.

The President of the San Francisco Federal Reserve, Mary Daly, spoke yesterday of her expectation that the Fed will hike interest rates to at least 2.5% by the end of the year as it continues to attempt to douse rising inflation that threatens the economy in a manner almost as serious as the Pandemic.

The level of support that was provided during the Pandemic is no longer necessary, but the Fed has been accused of delaying its withdrawal by being too cautious about the strength of the economy.

Supply chain issues leading to an overall shortage of spare parts and raw materials still exist, and the global shortage of semiconductors remains a concern. Overall, the risks for the economy remain heavily skewed towards rising inflation.

Producer prices, the level of which determines inflation at the factory gate and are seen as a gauge of future consumer inflation, rose by 11.2% year-on-year last month. From this it can be seen that consumer price inflation is still rising at an alarming rate.

Daly’s comments are not in any way considered to be an outlier, and it is entirely possible that she is speaking for the majority of FOMC members.

If it can now be accepted that a fed funds rate of 2.5% by the end of the year will be considered the neutral rate where monetary policy is neither expansive or restrictive, the question for the meeting on May 4th will be how much above neutral will rates have to go to bring inflation back under control?

The first week of May is lining up to be highly significant, with employment data and Central bank meetings set to dominate the financial markets.

Yesterday, the dollar index fell to a low of 100.21 and closed at 100.30. Dips are now considered to be buying opportunities, with the 100 level now something of a line in the sand.

With little data to drive the market for the rest of the week and early next, with only durable goods orders on Tuesday, it will be expectations for divergence in monetary policy that will drive the market.

But future turning bleaker almost by the day

There is a propensity amongst politicians to focus upon the data which suits their purposes best.

Sometimes, that is rear-view mirror data that shows how strong the economy was, and at other times they quote leading indicators that show the potential for the economy to perform better.

That habit is beginning to spill over into the actions of Central banks, in particular, the European Central bank.

Christine Lagarde has been in something of a muddle over the past month or so, first relying on outdated projections to back up her view that stagflation wouldn’t be an issue, then quoting past data for activity to underline the relative strength of the Eurozone economy.

Now, the conflict in Ukraine has become something of a truth serum for her as she has been forced to acknowledge the almost certain fall of the economy into recession while inflation continues to rise.

The issue facing the Eurozone economy is the divergence that has been seen in inflation raging from close to 4% up to 15% while the Central Bank has been hijacked into remaining committed to continued support for weaker economies.

As has been mentioned already, the ECB will also be meeting to set interest rates in the first week of May.

There were comments made by officials yesterday about the expected date of the first hike in interest rates as the Bank continues to support the economy, but with that support being gradually withdrawn.

Latvian Central bank Governor Martins Kazaks predicted the first rise will take place in July, while his colleague, Bundesbank President, Joachim Nagel agreed that the hike would come in the third quarter. In a rather unBundesbank comment, Nagel said that he is against what he called hasty hikes in interest rates despite being committed to returning inflation to 2%.

The single currency showed a little strength yesterday, but remains below the 1.0880 level. It rose to a high of 1.0867 and closed at 1.0850.

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.”