September 15, 2022
  • September 15, 2022

Week Ahead – Fed and BoE meet as inflation fears escalate

By on March 11, 2022 0

Global markets fell into turmoil after the arrival of Russian forces in Ukraine. Commodity prices have exploded and traders are betting that this shock will keep the inflationary fire burning for some time. The Fed and Bank of England are expected to raise interest rates next week to combat soaring prices, although the most crucial variable for their respective currencies may be whether there is a ceasefire. -fire in war.

A big business

Since the Russian invasion, the financial markets have turned into a huge war trade. Most assets are entirely driven by this theme, rising and falling with headlines from the war. Stock markets, the British pound and the euro suffer whenever sanctions escalate, while the US dollar, yen and commodities tend to benefit.

In the field of raw materials, the crippling sanctions imposed on Moscow will limit the supply of various metals, food and energy products. This is translating into higher commodity prices, so traders are betting that inflation won’t subside anytime soon. Market-based measures of inflation expectations have stormed, creating a headache for central bankers.

But it’s a very different puzzle for different central banks. For the Fed, this is just an inflationary shock. America is energy independent and its banks are practically not exposed to the collapse of Russian assets, so it will not derail the economy. But for Europe, it is a stagflationary shock. Consumers will be squeezed by the rising cost of living and the banking sector will take a serious hit, which could be a nightmare for growth.

This means that while the Fed may respond with big rate hikes to fight inflation, the ECB doesn’t really have that luxury because tightening in a slowing economy would raise the risk of a recession to uncomfortable levels. . In other words, this war has been a game-changer for Fed/ECB relative policy, which is also reflected in the demolition of the euro/dollar.

In the future, the course of the war will be the most important element. Markets appear to be pricing in a worst-case scenario at this point, implying that a ceasefire could trigger serious swings in “Ukrainian trade”. It may only be a matter of time as President Zelensky seems willing to compromise, for example keeping Ukraine out of NATO.

Fed – all about points

The main event will be the Fed meeting on Wednesday. A quarter-point rate hike is fully priced in, so market reaction will largely depend on what Chairman Powell says at his press conference and interest rate projections in the dot plot. update.

The last points of December indicated only three rate increases for this year, but market prices currently imply six and a half. Therefore, it’s a safe bet that the points will be revised upwards – the question is exactly how much. Will officials report four, five or six rides?

There is a strong argument it could be six, which would probably be the most bullish result for the dollar. The labor market is tight, wages are soaring, consumption is solid and inflation is burning. The latest CPI print came in at 7.9% in annual terms and given the latest spike in energy prices, the next could be even hotter.

Another argument is that the Fed wants a stronger dollar at this point. A stronger currency can help calm inflationary forces more quickly, without the need to over-tighten. In this sense, talking is both cheap and advantageous. It also prompts President Powell to adopt a more hawkish tone.

On the data front, the latest edition of retail sales will be released a few hours before the FOMC decision.

BoE – deploy the big guns?

The Bank of England will conclude its own meeting on Thursday. With the labor market firing on all cylinders, inflationary pressures mounting, and the latest corporate surveys pointing to accelerating growth, investors are confident another rate hike is on the menu.

A steady 25 basis point (bp) rate hike is already priced in and money markets are implying a 15% probability for a 50 bp move. This begs the question: how aggressive does the BoE want to be?

The pound has been devastated by the Ukraine crisis and the BoE is unlikely to change this momentum unless it surprises markets with a “double” rate hike. However, this is highly unlikely. Raising rates with reckless abandon doesn’t make sense from a risk management perspective when the economy is already heading into a downturn.

Overall, the markets seem to have become too aggressive with the BoE hikes. A total of 100 basis points is priced in by June. There are only 3 meetings so far, which means traders have already predicted a “double” upside over the next few months. This leaves room for disappointment if the BoE hesitates to deploy the big guns. For the pound to benefit from a recovery, a truce in Ukraine is necessary.

The BoJ is unlikely to join the party

The Bank of Japan will also meet on Friday, but don’t expect much. The world’s third largest economy has barely escaped deflation, wages are not rising and consumers will be squeezed given the country’s reliance on energy imports.

Therefore, while the BoJ wants to signal an exit from decades of easy money policies, it is difficult to do so with inflationary momentum still subdued. The next step in the normalization process would be to widen the range in which Japanese yields are allowed to trade, essentially raising the cap on yields.

As for the yen, with the BoJ still on the sidelines, its fate is linked to risk sentiment. However, the dollar – which also benefits from safe-haven flows – may be an exception. The dollar/yen has skyrocketed as yield differentials have widened lately and it is hard to see that trend reversing until the BoJ executes its own U-turn.

Commodity currencies in the spotlight

The Australian and New Zealand dollars typically trade alongside risk appetite, but that relationship has broken down lately, with the two currencies defying the gloom in stock markets to instead focus on the relentless rise in prices. raw material prices.

Next week will bring crucial releases from both economies. Australia’s latest employment figures are released early Thursday, ahead of New Zealand’s fourth quarter GDP statistics later in the day. There is also the monthly barrage of data from China on Tuesday.

Finally in Canada, the latest inflation report will hit the markets on Wednesday ahead of retail sales on Friday. Unlike its commodity currency cousins, the loonie failed to capitalize on the commodity boom, which is a bad sign.

The stars have aligned lately with soaring oil prices, a strong domestic economy and market prices in the Bank of Canada‘s aggressive rate hikes. If the loonie could not rally under these conditions, will it rally?