Uncertainty surrounding last week's Federal Reserve meeting was unusually high. In the end, not only did the Fed not raise rates, but chair Warsh sounded rather dovish.
The dollar ended the week lower against all of its major counterparts. While Warsh affirmed the Fed's commitment to its inflation mandate, he gave markets no indication that rate hikes were the mechanism to achieve it. This has dampened bets on a September rate rise and, more troublingly, appears to have eroded the Fed's inflation-fighting credibility, stoking fears of a rout in long-dated bonds. The dollar appears to have begun a new leg lower against European currencies, a move exacerbated by the unwinding of dollar longs following coordinated US-Japan FX intervention in the yen.
Warsh’s apparently lackadaisical attitude towards both inflation and the march to higher long term rates has clearly unsettled the bond market. We will subsequently be paying very close attention to the long end of the US curve and the quarterly refunding statement on Wednesday, when the US Treasury will announce the size of the bond auctions for the next quarter. That aside, this week's focus will be on the apparent signs of progress towards a US-Iran peace deal and the slate of July labour market reports out of the US, culminating in the key payrolls report on Friday.
GBP
Last week’s Bank of England meeting ended on a considerably more dovish note than the 6-3 vote for keeping rates unchanged suggests. The communications accompanying the decision imply that significant inflation surprises will be needed to move any further votes to the hike column. The MPC pointed to clear signs of disinflation and little evidence so far of second-round effects, while the inflation forecast was actually trimmed to show a peak of closer to 3% later in the year. This mismatch between the vote and rhetoric is unusual and, in our minds, points squarely to a stark divide between the hawks and the doves on the committee.
The hawks will argue that the spike in energy prices warrants insurance tightening, though that argument only really holds if the shock threatens to feed into underlying inflation, and it doesn't appear as though the majority of the committee believes it will. Our view remains in favour of no change in rates this year, and even markets are beginning to rethink. This dovish shift was, however, swamped by the news from the Federal Reserve the day before, so sterling stabilised against the euro and managed a significant rally against the dollar.
EUR
Macroeconomic data out of the Eurozone last week bolstered market bets that the ECB will hike rates again at its September meeting. The Euro Area economy grew at a significantly faster than expected pace in the second quarter of the year following a boost in AI investment and an increase in government spending. This proved more than enough to offset downside from the Iran war and spike in energy prices, which so far appears to be having a surprisingly muted impact on activity in the common bloc. Core inflation also surprised the upside, indicating that the risk of second round effects from the energy price spike has not fully dissipated.
Swap markets continue to price around a 90% chance of a 25 bp hike at the ECB’s September meeting, which is buoying the common currency back towards the top of the recent range. We think that this is now effectively a done deal even in the event of a peace deal, as not only does the Euro Area economy appear resilient enough to withstand further tightening, but the bloc is more exposed to imported energy inflation than across the Atlantic.
USD
Chair Warsh is clearly determined to break with his Federal Reserve predecessors. He has managed to restrict communications to markets and vowed to curtail them further in the future. Further, he suggested that he sees Fed rates as playing a less critical role in controlling inflation, and appears to be comfortable with the steady sell off in the long end of the US curve rates, as he expects it to do the job for the Fed. Whatever the theoretical underpinnings of the approach, it is clear that neither the currency nor the bond market is happy with the change.
Attention now shifts to the July payrolls report on Friday. Economists are expecting a rebound from last month's somewhat disappointing numbers, but no change in the overall trend of a modestly-growing labour market. In light of Fed dovishness, FX intervention in the yen and signs of progress towards a US-Iran peace deal, we see the path of least resistance for the dollar as lower.
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