“...now it looks like things are finally comin’ around"
- McFadden & Whitehead, Ain’t No Stoppin’ Us Now
Last week, we reflected on the recent USD appreciation vs. the EUR – a move that we have been arguing in favour of for many months. This reflection has not reduced our commitment to this USD positive theme. Indeed, if anything, the near-term macroeconomic dynamics continue to point to widening differentiation, suggesting that there is still further to run.
At the heart of the debate is inflation. Over recent weeks, we have discussed the impact and implications of inflation on the global economy and different currencies in particular. While large elements of the current inflation dynamic are global in nature, it is important to point out that within this overall context there are idiosyncratic inflation dynamics (with implications for domestic demand divergence), different levels of monetary stimulus, different growth and fiscal trajectories and thus very different central bank reaction functions, all of which likely drive a higher currency volatility on divergence.
Inflation in Europe has been driven in some part by the base effects from the reversal of the German (stimulus) VAT cut, and also by the pernicious gas price rises that have been most exaggerated in Europe and the UK (gas price rises being more modest in the US). But it is important to note that the global supply chain disruptions have not just been a factor driving inflation in the eurozone, but also slowing the dominant manufacturing base and thus directly impacting production and growth. More recently, a renewed Covid wave has led to tighter restrictions that will also likely weigh on Q4 growth.
From a policy perspective, the European Central Bank (ECB) has maintained the view that the trajectory of inflation for much of 2022 is likely to be lower and that inflation at the forecast horizon remains below target (thus the three conditions necessary for ECB rate rises will not be met in the near term), and the market has started to price out its expectations of rate hikes in 2022.
In the UK, the gas price rise was equally exaggerated. But the UK has also faced labour market frictions (Brexit-related and other more persistent skills shortages, such as lorry drivers), and supply disruptions, not just from global supply chains, but also from the UK’s new trading relationship with the EU. Thus, a tighter labour market.
The monetary response in the UK is therefore very different. The Bank of England (BoE) projections see inflation well above target under constant rate assumptions, and marginally below target under the conditional projections (market implied rate forecasts at the time of the November meeting) of Bank rate at 1.0% by the end of 2022. Rate hikes in the UK are almost inevitable over coming months. From a currency perspective, the pertinent question is likely whether the BoE, and thus the currency, can live up to the significant rate hike expectations of the market.
In Australia, the situation is very different. While historically, Australia (and its bond market) have traded with a yield premium over much of developed markets (DM), and thus it can certainly be argued that there is a significant monetary stimulus (current quantitative easing legacy aside), the underlying inflation dynamic is not as convincing to me as the market interest rate pricing might suggest.
The Reserve Bank of Australia (RBA) Governor was clear that underlying inflation is picking up, but only gradually (indeed the data for Q2 shows core inflation just edging into the 2-3% target band with some likely transient housing effects included), and furthermore, that while wage growth remains sluggish, the RBA could continue to look through near term inflation pressures, emphasising the RBA statement language “prepared to be patient”.
In summary, markets are pricing rate hikes in the eurozone and Australia that we feel the central banks are unlikely to be willing or able to deliver – even with the current unusually wide distribution of possible inflation outcomes. In the UK, there is indeed a strong case for rate hikes from the BoE, at least in part due to the change in economic structure of the UK as a result of Brexit. However, headwinds posed by fiscal tightening, the effects of inflation (especially energy costs) and even the impact of higher rates suggest it is likely difficult for the BoE to tighten as much as the markets are currently expecting.
The US, on the other hand, is likely a different kettle of fish altogether (to use an old-fashioned English saying). The Federal Reserve (Fed) communication around the initial stages of normalisation has likely been conservative with respect to inflation, as a conscious decision to remove any additional uncertainty (tantrum prospect) around the taper. Market pricing of US rate hikes has therefore remained below the median Fed dots (an indication of the Fed’s own view).
However, over the coming few weeks, we will get the release of the US employment report for October, inflation for November, and the updated Summary of Economic Projections (SEPs) from the Fed. Given that the surge in inflation pressure, as measured by breakeven yields in the US (and more acute inflation repricing across the rest of DM), happened after the release of the September SEPs, it is likely that there is a marked upward shift in the projections in December, and thus potentially further upside revisions to the Fed ‘dots. Especially if, as we expect, there have been hawkish employment and inflation data releases prior to the meeting. All this against a backdrop in the US where recent earnings releases from key consumer demand barometers (Walmart, Home Depot, Macy’s) have surprised to the upside.
Essentially, we remain positive on the USD, as we expect further repricing of the front end of the US rates curve, at least relative to the rest of DM, where the case for rates hikes is in our mind less compelling than current pricing suggests.
The next month is likely very important for the US economic narrative and the resultant reaction function of the Fed, but from where we stand there is little to suggest that the US is stoppin’ now.
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