30 August 2022: Race to be PM enters final stage

Race to be PM enters final stage

30th August: Highlights

  • Is the UK already suffering stagflation?
  • Powell maintains Hawkish bias
  • Eurozone facing several harsh winters

GBP – Truss still ahead but Sunak may see a late surge

Conservative Party leadership front-runner Liz Truss has cancelled a televised interview with the BBC this week, citing time constraints. This has prompted her rival for the role to label her campaign as being without substance and insufficiently robust to stand up to scrutiny.

Truss has been under pressure to confirm that should she win the election, the result of which will be revealed next Monday, she will consider blanket support for the entire country to relieve the concerns over the cost-of-living crisis.

It is understood that Truss favours tax cuts as the most suitable method of reviving the economy, a method that Sunak has labelled as unaffordable.

With less than a week to go before the result is announced, Truss appears to have adopted a defensive position believing that the policies that she has set out have placed her in a winning position.

Sunak will use the time to attack the viability of her proposals, since he has continually been portrayed by his supporters as a safe pair of hands as far as the economy is concerned.

In its efforts to phase out imports of oil from Russia, the UK is looking into further drilling contracts to extract oil from the North Sea. This had been considered an expensive choice in the recent past, but with the cost of energy having skyrocketed in the past year, its viability is being reconsidered.

Stagflation, the term given to an economy in which inflation continues to rise while the economy is slowing, has long been considered an almost mythical beast, since the conditions that need to exist for such an event to occur are hard for economists to imagine.

However, the war in Ukraine which has led directly and indirectly to slowdown in both the UK and mainland Europe, as well as high and rising inflation, is leading to such conditions being met.

Stagflation creates a spiral of contraction in which Central Banks tightening monetary policy to deal with rising inflation directly contributes to slowing demand, which eventually leads to stagnation.

With the traditional end of the summer lull having taken place and most G7 Central Banks returning next month, volatility in the financial markets is likely to increase.

Last week, Sterling having broken below its low for the year versus the dollar continued to exhibit weakness. It fell to a low of 1.1717 and closed at 1.1739. On a holiday shortened day yesterday, it fell to a low of 1.1648 and closed at 1.1719.

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USD – Lower PCE encourages Powell to keep up inflation fight.

The Federal Reserve has continually favoured the release of data for Personal Consumption Expenditures as a more reliable measure of inflation due to its broader level of components.

The release of the latest figures for PCE which took place on Friday will have been encouraging for the Central Bank as they showed that the rate of increase has slowed. Month-on-month prices fell by 0.1% having risen by 1% in June. This led to a year-on-year rise of 4.4% versus 4.6% previously.

Jerome Powell, the Chairman of the Federal Reserve, spoke at the conclusion of the Central Bank’s Symposium in Jackson Hole, Wyoming on Friday and, as expected, remained fairly hawkish on inflation. In fact, on balance, he was perhaps slightly more hawkish than markets expected.

His words had the effect of pushing the chances of a seventy-five-basis point increase in short term rates at the next FOMC meeting above 70% and saw the dollar strengthen.

The belief that the country could yet escape a genuine recession was reinforced with the release of preliminary GDP data for the second quarter, which showed that the economy contracted by less than previously believed.

The latest figures show a 0.6% fall in GDP versus a 0.9% fall in the first quarter. Powell has been vehement in his belief that the economy will escape from seeing a full-blown recession. He acknowledged that there may be pockets of weakness both sector by sector and in certain areas geographically, but these will be covered overall by stronger growth elsewhere.

With Powell driving market expectations higher, his remarks contrasted with the words of some of his colleagues on the FOMC, who appear to be considering voting for a fifty-point hike next month.

Powell will most likely say that despite some good news on inflation, now is the time to push home the determination that inflation will be beaten.

There is still a view among prominent economists that the U.S. economy is heading for a recession that may not begin until next year. If that is the case, it is possible that the Fed will have raised rates well into restrictive territory and could face calls to bring them back to neutrality, which is roughly where they are now.

The hawkish comments from Powell coupled with the raining of expectations of a seventy-five-basis point hike at the next FOMC meeting pushed the dollar to a high of 109.27 last week, closing at 108.82. Yesterday it rose to a high of 109.47 but ran out of steam and closed at 108.72.

EUR – Uncoupling of electricity price vital to recovery

The Belgian Interior Minister spoke over the weekend of his concern that the Eurozone is facing five or possibly even ten winters of discontent unless something is done urgently to decouple the cost of electricity from the cost of gas.

Within the European Community, the cost of electricity is intrinsically linked to the wholesale price of gas. This means that as the price of gas increases, so does the cost of electricity.

While the majority of electricity is produced using gas, this is by no means the full story, with a large and rising portion produced from sustainable sources such as solar and wind turbines.

So, despite the fact that Europe is desperately trying to wean itself off a reliance on energy imports from Russia, the nations of the Eurozone are paying more than they should for electricity.

The ECB is facing further pressure over the slump in economic output this year, with forecasts that inflation could top ten per cent as the price of gas continues to surge.

With another fifty-basis point hike in interest rates almost certainly a done deal for next month, a deep and long-lasting recession if looking more certain.

There was some good news on the energy front late last week, with Germany announcing that despite the slowing down of gas supplies from Russia, it is ahead of its target to replenish stocks, with the job 85% complete.

While this is a significant development, it could still mean that the country must introduce rationing unless the supply from Russia returns to earlier levels. Currently, this looks to be unlikely given the maintenance issues facing the delivery of gas.

Outspoken ECB policymaker Martins Kazaks, the Governor of the Latvian Central Bank, warned last week that the Eurozone economy faces a period of stagflation as the expected recession won’t necessarily bring down the rate of inflation since energy usage will only be marginally reduced.

Kazaks believes that the front-loading of interest rate hikes is a reasonable policy given the rate at which inflation is still expected to rise.

The euro is set to remain weak against the dollar for possibly the rest of 2022 although with hikes at both the next ECB and FOMC meetings seen as done deals, the Fed may taper first. It is still to be seen if that gives any degree of support to the single currency.

Last week, the euro fell to a low of 0.9900 and closed at 0.9964. Yesterday, it gained marginally, closing at 0.9996.

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.”