4 July 2023: The fifty-basis point hike brought a recession closer

4 July 2023: The fifty-basis point hike brought a recession closer


  • A change of emphasis at the MPC
  • Yield curve inversion deepest since 1981
  • The IMF Chief economist sees inflation as being “far tougher” than first expected
GBP – Market Commentary

Greene begins in a hawkish vein

The decision taken by the MPC last month, in response to the May inflation data, has brought the prospect of a recession close according to a renowned investment manager in the City.

The fact that the Bank was forced to change tack on its cycle of interest rate hikes after so long shows that it is far from being on top of the problem.

The data releases for May and the current level of inflation have led Schroders Investment Managers to believe that the base rate will reach 6.5% later in the year. It is probable that a further fifty-point hike will be agreed in August before the Bank feels comfortable returning to two twenty-five-point hikes later in the year.

Megan Greene, who joins the MPC this week, spoke in an article published yesterday by the Financial Times of her view that Central Banks would do well to be cautious about expecting inflation and therefore interest rates would settle back down to their now long-established level.

There are too many imponderables within the global economy currently to be certain that “normal service will be resumed.”

Greene, who officially began her term as an independent member of the MPC yesterday, doesn’t appear to be ready, or willing, to take up the dovish position of her predecessor, Silvana Tenreyro.

Greene echoed Andrew Bailey’s recent comments in which he challenged the view that once the base rate had reached its highest level, that the Bank would be forced to quickly introduce rate cuts to stave off a recession.

She went on to say that the “r-star,” as the neutral rate of interest is termed, had risen and monetary policy is not as tight currently as the market believed.

She believes that machine learning and the growth of artificial learning have advanced at a rate no one expected, and this will lead to significantly higher productivity, which in turn will see a rapid increase in growth.

Greene acknowledged that it will be a challenge to contribute to a decision process that leads to the highest rate of inflation amongst developed economies falling.

In absence of any tier one data releases, the pound drifted yesterday, falling against the dollar to a low of 1.2658 but recovered to close barely changed from Friday’s close at 1.2693.

USD – Market Commentary

Powell says regional banks are exposed to $2.9 trillion of troubled commercial real estate loans

One of the more permanent indicators of economic well-being has turned around and is now predicting a recession.

The spread between the price of two year versus ten-year treasury notes has inverted to its widest level since 1981. This reflects the market’s concern that the continued hiking of interest rates by the Fed to combat inflation will tip the U.S. economy into a recession.

Signs of strength in recent economic data releases have prompted a view that the FOMC will continue to increase interest rates to bring inflation under control.

The inversion in the yield curve is deeper than was seen in either the period immediately following the Pandemic or the regional banking crisis that briefly threatened earlier this year.

Every time since 1955 that the yield curve has shown such an inversion, it has been followed within two and a half years by a recession. This won’t be news to Jerome Powell and his colleagues on the FOMC, and it will most likely cause them to proceed with caution.

It is the “natural order” that the rate of interest the Government must pay to borrow money increases the longer the term, but when the curve “inverts” and borrowing in the shorter-term becomes more expensive, it has always been a pointer towards a contraction of the economy.

Only once in that time has this proven to be a false signal, and this is why the market is showing a great deal of concern.

The recent comments from members of the FOMC, most commonly from Its Chairman, point very clearly towards a further hike at the meeting later this month, and a total of three more hikes this year.

While the Fed continues to profess to be “data-driven,” this week’s release of the June employment report as well as the deep inversion of the yield curve may induce further caution.

The dollar index was barely moved at the prospect of a recession, initially gaining yesterday as the expectation for a widening of the gap between activity between the U.S. and Eurozone became clearer. It reached a high of 103.27 before falling back to close at 102.97.

Jerome Powell added another note of caution late yesterday when he admitted concern over the size of the doubtful loan portfolios of regional banks that contain two point seven trillion dollars in troubled commercial real estate loans. Given the failure of three regional banks earlier this year, this is an area of the economy that the Fed will be concerned about.

EUR – Market Commentary

“Terminal rate” now expected to be 4%

As inflation remains an issue in the world’s developed economies, the level at which Central Banks feel comfortable in “calling a halt” to their cycles of interest rate hikes has risen.

Having paused last month, the Federal Reserve is expected to add three more hikes this year, the Bank of England, still having failed to control inflation increased the size of hike at its last meeting, and now respected market observers believe that the ECB will see interest rates at 4% before it is able to end its own cycle of hikes.

This is according to Morgan Stanley the respected U.S. investment bank. This is an increase from 3.75 and follows an almost certain hike at July’s meeting and the continued wrangling over what will take place in Septembers.

The prospect of further rate increases following the August “pause” is still the subject of much debate and almost daily criticism of the ECB.

Recently, Italy and Portugal appeared to have joined forces to rail against the continual tighten in monetary policy, while the Chief Economist at the International Monetary Fund spoke of his view that inflation will continue to be more persistent than Central Banks had realized and this will lead to tighter conditions throughout the Eurozone.

Pierre-Oliver Gourinchas was questioned at the ECB Annual Conference last week about how a recession can be avoided. He responded by saying that no Central Bank can say with certainty when rates will become sufficiently restrictive on demand to cause inflation to fall towards their target., but it is also unwise to intimate that rates will rise “come what may.”

Data for manufacturing output was published by Italy, France, and Germany and in each case the results were disappointing, falling even deeper into contraction.

The consolidated data for the entire eurozone also fell but not by as much as had been feared.

Overall, it is becoming clearer that the actions of the ECB are likely to prolong the recession that the Eurozone is undergoing currently, and it is likely that there will be a “lively debate at both this month’s meeting and the one in September.

The common currency was afflicted by malaise that affected the entire market yesterday. There is a great deal about tiger monetary policy, which should be supportive for the currency, driving economies into recession which may precipitate a rapid volte-face.

The euro fell to a low of 1.0870, but quickly recovered to close marginally higher at 1.0911.

Have a great day!

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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.