29 October 2021: Interest rates could reach 3.5%

Interest rates could reach 3.5%

29th October: Highlights

  • Economy facing a blow worse than Covid from Brexit
  • Supply Chains issues hit Q3 growth
  • ECB sticks with negative rates despite raging inflation

OBR predicts higher mortgage rates will burst bubble

Rishi Sunak’s Budget that was presented in full to Parliament this week has provided a limited degree of optimism over the medium-term fate of the UK economy, but there are still several obstacles to be negotiated before the country can move forward in a post-Covid environment.

It seems that the middle class are going to shoulder the majority of the burden of higher taxation as the Government’s levelling up plan becomes more than just a geographical exercise.

There have been no major criticisms of the Government’s spending plans for the coming year although, as is fairly normal, no individual sector will be happy with their part in their funding.

Despite hopes to the contrary, the country is not going to wake up one morning to find that Coronavirus has disappeared completely, so the post-Covid era will be more of a case of living with the virus and any variants. As we learn to live with continued booster vaccinations, the next issue that needs to be put to bed is Brexit.

It seems that Northern Ireland remains the most problematic issue remaining, but it is challenged for prominence by the continued dispute with France over fishing rights.

The row blew up again yesterday as the French arrested a UK trawler in a row over whether the EU has issued several UK vessels with permits to fish.

The Foreign Secretary has already commented that the French actions are disproportionate, and she has called the French Ambassador to the Foreign Office for discussions.

The Office for Budget Responsibility in its six-monthly briefing about the health of the UK economy has said that the full implementation of Brexit will cost about 4% in GDP growth over the next five years.

This assertion has been roundly rejected by Brexiteer members of the Government who believe that this doesn’t acknowledge the positive outcomes that are in the pipeline.

The market is now gearing up to find out how the Bank of England will react to the probability of higher inflation when the MPC meets next week. It has been forecast that over the medium term, interest rates could reach as high as 3.5% which would be a major blow to both homeowners and those looking to enter the market.

Yesterday, the pound rallied versus a weaker dollar. It managed to break above the 1.38 level briefly, making a high of 1.814 but fell back to close at 1.3788 as traders saw that the UK faces its own challenges.

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Will the FOMC stick to its guns

GDP is never equal to the sum of its parts, which is why there is often a level of disappointment when a run of positive data culminates in a GDP result that is significantly underwhelming.

While Q3 U.S. growth was expected to be a lot lower than Q2, the number that was released yesterday dented confidence in the economy and may have changed the thought processes at the Federal Reserve.

This is another reason it doesn’t pay to second guess a Central Bank. No matter how certain the market is that it will act in a certain way, circumstances may blow plans off course.

GDP growth in the period between July and September was a disappointing 2%, following 6.7% in the previous quarter.

It may be a case of Q2 being a one-off as the country emerged from lockdowns and single items like consumer demand, travel and hospitality returned, and Q2 illustrating the significance of the issues in logistics that have hit supply chains as demand remains high, but supply is struggling to keep up.

If manufacturers are unable to obtain sufficient quantities of raw materials, and they cannot secure contracts for future deliveries, then this will hit the economy hard but also the result will feed through very quickly.

Add to this the fact that inflation continues to rise as fuel sees a return to pre-Covid levels, and the spectre of stagflation becomes a real threat.

The outcome of the FOMC meeting that will take place next week is now in jeopardy. The Federal Reserve is the flag bearer for the U.S. economy and expected to be positive and have its finger on the pulse.

Even if Jerome Powell is aware that GDP growth was going to be even lower than the market’s 2.8% expectation, he has continued to prime the market for a reduction in support. It may very well be that he believes that the country can deal with a little pain in order to get inflation back under control, but there is no guarantee that the Fed won’t follow the ECB into a lower for longer stance.

The dollar index reacted badly to the data. It fell to a low of 93.27, closing at 93.36. Having broken the 93.50 support, it remains to be seen if the market will aggressively sell the dollar if it will remain cautiously optimistic about the outcome of the FOMC meeting.

Lagarde’s rhetoric points to continued dovish outlook

Looking at the other major G7 economies, it seems that the ECB may have its policy right, despite raging inflation exerting pressure on the governing council to tighten monetary policy.

Christine Lagarde has been determined not to repeat the mistakes seen previously when the Central Bank has been lulled by improving data into being overly hawkish about rising inflation.

Yesterday, inflation data was released for Germany that will have made the Bundesbank very uncomfortable, but it seems that Lagarde is prepared to see additional pain in the Eurozone’s dominant economy if it means that the recovery can be further solidified.

Inflation rose to 4.6% so far this month, a. rise from 4.1% in September and a market expectation of 4.5%.

The situation in the Eurozone is not dissimilar to what is currently being experienced in the U.S. with high inflation and a softening economy. It remains to be seen how the Fed’s reaction differs from that of the ECB.

The ECB’s projection is for interest rates to remain negative until this time next year, believing that an eventual reduction in the level of support it provides will reduce the level of inflation.

This may eventually be the correct assumption, but the rise in the wholesale price of gas has shown how unexpected developments can blow assumptions off course. The ECB has very little in the way of wiggle room should another crisis emerge that hadn’t been foreseen.

Christine Lagarde, the ECB President, in her press conference following the Bank’s rate announcement, acknowledged that inflation may remain more enduring as she tempered only very slightly her dovish stance on monetary policy.

Her words were interpreted as being more open to tighter policy should the need arise.

Today’s release of preliminary GDP for Q3 will show a dramatic fall from the rate of growth seen in Q2. The 14.3% rise in GDP in Q2 will never be repeated, with a more modest 3.5% expected for Q3.

The euro made significant gains as the dollar fell following yesterday’s data.

It reached a high of 1.1692, closing at 1.1681.

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.”