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Sterling tanks to record low on dollar after UK budget

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26 September 2022

Written by
Enrique Díaz-Álvarez

Chief Risk Officer at Ebury. Committed to mitigating FX risk through tailored strategies, detailed market insight, and FXFC forecasting for Bloomberg.

The past week has been one of the most tumultuous in currency markets in quite some time.

S
terling was very much in the spotlight this morning, as the UK currency crashed to a record low against the US dollar below the $1.04 level, before retracing some of its losses. Markets have reacted violently to Truss’s deficit-busting budget announcement, which has vapourised both the Gilt market and the pound. While the energy bill freeze should allay the risk of recession in the near-term, investors believe that the measures announced will lead to higher inflation and a massive increase in borrowing in the medium-term. There is even speculation this morning that the BoE could announce an emergency rate hike in order to stem the slide.

The Federal Reserve’s unambiguous hawkishness last week also received plenty of attention, with a host of other central banks also hiking rates and sounding the alarm on inflation (Switzerland, Sweden, South Africa and the UK, among others). The Bank of Japan was the one exception, but even authorities there intervened in the market to arrest the relentless depreciation of the yen. Bond yields rose worldwide, risk assets plummeted, and investors flew to the safety of the US dollar, which rallied massively against almost every currency.

In an inflationary context, currency devaluations are a most unwelcome development, and we expect fiscal and monetary authorities to follow Japan’s footsteps and start pushing back, either rhetorically, with further hikes or outright intervention. Bank of England officials should get the ball rolling after the rout in the pound. The Eurozone will be in focus as well, starting with the market reaction to the right-wing victory in the Italian elections and followed up by the key September flash inflation report out Friday. At any rate, the disaster in UK bond and currency markets suggests that markets’ patience with massive fiscal deficits has finally run out.

Figure 1: G10 FX Performance Tracker [base: USD] (1 week)

Source: Refinitiv Datastream Date: 26/09/2022

GBP

The Bank of England’s relatively uneventful meeting on Thursday was followed by a dramatic trading day Friday, and then again this morning. Prime Minister Truss delivered a budget full of expensive tax cuts that implies a massive expansion in deficits and bond issuance, and markets did not take the news well. Gilts had perhaps their worst trading day in history, with surreal moves of 50 basis points or more, and the pound crashed against every other major currency, particularly the US dollar.

Figure 2: GBP/USD (September 2022)

Source: Refinitiv Date: 26/09/2022

Economic news will become somewhat irrelevant for some time, as all eyes are now on the Bank of England’s reaction to the Tories’ openly inflationary budget. All bets are off now, and we would not rule out the possibility of an inter-meeting emergency hike in rates to support the currency. At any rate, markets are pricing in a forceful response, including 200 basis points in hikes by year-end and a terminal rate closer to 6% than 5%.

EUR

The PMIs of economic activity weakened modestly, as expected, to levels consistent with an economy possibly headed to stagnation or a shallow recession, with a notable divergence between Germany and France, which is still growing. The euro was dragged down by the general flight to the dollar, but it is worth noting that rates rose more in the Eurozone last week than in the US, as the ECB catches up to reality and turns ever more hawkish.

nflation in September is expected to reach yet another record high in both the headline and core numbers, and the euro devaluation is only making the problem worse. Even after last week’s massive increase in rates, markets are only pricing in 3% as the maximum level to which the ECB will raise rates, which seems way too low to us.

USD

The Federal Reserve hiked by 75bps and sent an unmistakably hawkish message in the “dot plot”, where the median member now expects its rate to end 2022 above 4.5%. Chair Powell suggested that rates will go up as long as inflation remains unacceptably high, even at the cost of increased unemployment.

Figure 3: FOMC ‘Dot Plot’ [September 2022]

Source: Refinitiv Datastream Date: 26/09/2022

The only macroeconomic news of note this week is the PCE inflation report on Friday, but on the other hand we will get an unusually large number of speeches by Federal Reserve officials. We don’t expect any significant deviations from Powell’s hawkish line from last week’s meeting.

CHF

The Swiss National Bank raised rates in line with expectations last week, hiking by another 75 basis points to 0.25%, thus ending the era of negative interest rates in Europe. The bank’s rhetoric suggests that additional rate hikes are a done deal, and markets are now more-or-less fully pricing in another 75bp move at the December SNB meeting. In its communications, the bank noted it was raising rates due to ‘the renewed rise in inflationary pressure and the spread of inflation to goods and services that have so far been less affected.’ The franc did, however, weaken following the announcement after Chairman Jordan warned that the SNB would intervene against aggressive moves in the FX market.

Despite the sell-off following the meeting, the franc still ended the week as one of the better performers in the G10, as higher rates globally, and frantic moves in bond yields in general, caused investors to favour the safe-havens.

AUD

A broadly strong US dollar pushed the Australian dollar to its weakest level since May 2020 last week, around the 0.65 level on the USD.

The release of the PMI business activity indices for September were the main data release last week. All three indices were up slightly from the previous month and continue to indicate that the Australian economy is expanding, albeit at a very modest pace. The composite index rose to 50.8, marking the eighth consecutive month of expansion in the private sector. We think that the data suggests that the economy is holding up relatively well, despite high inflation and aggressive rate hikes from the Reserve Bank of Australia.

August retail sales data will be published on Wednesday. Aside from that, without any more domestic data out this week, we think that risk sentiment and USD dynamics will be the main drivers of AUD.

CAD

In line with most currencies, the Canadian dollar depreciated against the broadly stronger US dollar last week and is now trading near its lowest level since July 2020, above 1.35 per USD. Both headline and core inflation data for August surprised to the downside last week, which did not help the Canadian currency, given its implications for BoC interest rate policy. Canada’s annual inflation rate slowed to 7% in August, from 7.6% in July and below market estimates of 7.3%, amid a large pullback in energy prices.
This decline in inflation caused expectations of rate hikes by the Bank of Canada to moderate. Markets now expect the BoC to soon end its hiking cycle, and are now pricing in a 50 basis point hike in October and a 25 bp one in December. August GDP numbers will be released on Thursday. Aside from that, we think that CAD will largely be driven by events elsewhere.

CNY

The yuan continued to trade lower against the broadly stronger US dollar last week, with the USD/CNY pair rising above the 7.15 level this morning and its highest level in two-and-a-half years. While much of the sell-off in the currency has to do with the broad rally in the dollar, widening interest rate differentials between the US and China means that the yuan has put in an uncharacteristically poor performance of late, to the point where it has depreciated against most of its EM peers in the past two months.

The People’s Bank of China has taken steps to alleviate downside pressure on the currency, although this appears to be having limited impact thus far. This includes raising the FX risk reserves requirement for financial institutions that purchase forwards to 20%, from zero. The PBoC has also set stronger yuan fixings, though again with little real impact on reversing the currency’s slide, there is growing speculation that additional measures could be announced in the coming days.

Economic Calendar (26/09/2022 – 30/09/2022)

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