Markets are finally beginning to take notice of the renewed US-Iran hostilities and surge in oil prices, which last week jumped back above $100 a barrel.
Stocks retreated and the dollar gained against most of its peers as investors sought refuge in the safe havens, while net commodity exporters were favoured due to expected improvements in terms of trade. Expectations of central bank rate hikes continue to mount, and markets now see a non-negligible chance of a hike from the Fed as soon as this week's meeting. Last week’s rally in the dollar was notable given the announcement of Trump's latest attempt to launch tariffs and get them past the US judiciary, reinforcing the view that expectations for monetary policy are again the biggest factor driving currency moves.
News over the weekend that the US and Iran are suspending attacks has brought about some mild relief for risk assets so far today. The main focus this week will, however, be the July meeting of the Federal Reserve on Wednesday. We still expect no change, though markets see the meeting as a “live one” and, at the very least, the FOMC will keep its options open to raise rates in September. The Bank of England also meets on Thursday, though no action is expected. The week will be bookended by the Eurozone flash inflation report for July on Friday.
GBP
Andy Burnham’s first week as Britain’s prime minister is in the books. His surprise pick of John Healey as chancellor has gone down well given his perceived fiscal responsibility and experience in the Treasury. Yet we are beginning to see a few jitters among investors as the tax cuts unveiled so far both appear unfunded and raise the risk of tax hikes and additional borrowing down the road. At risk of sounding overly cynical, we see an element of sugar-coating the pill here, as these cheap to deliver but politically potent measures look likely to be followed with more aggressive tax raising measures in the autumn.
There are signs emerging that his government will pursue such tax-and-spend policies, while looking for "maximum flexibility" under the fiscal rules. We interpret the latter as a sign that deficits, debt and gilt issuance will rise even further - an unwelcome cocktail for the pound and gilts. Currency markets seem to agree with our diagnosis and sterling has retreated sharply against the euro over the last two weeks. We do not expect much new information from the Bank of England meeting this week, since last week's wage and inflation numbers came in line with consensus.
EUR
As expected, the European Central Bank left rates unchanged last week and refused to explicitly commit to a hike path, emphasising that its decisions remain data dependent. President Lagarde’s tone was hawkish, however, and she firmly kept the door open to another rate increase in September by saying that the bank would have a lot more information to go off by the next meeting.
The combination of a rebound in energy prices, the better tone in economic data and Lagarde’s hawkish communications have led traders to price in an 80% chance of another hike at the September meeting. The surprising rebound in the July PMIs lends further support to this view. This week's inflation data could go a long way towards sealing the deal for a hike, as economists expect the headline index to remain very close to 3%, i.e. meaningfully above the ECB’s target.
USD
Economic indicator data released last week confirmed the generally positive tone in the US economy. Second-quarter GDP data out this week is expected to show that the US economy is growing at a near 6% pace in nominal terms, with no sign of a slowdown, and inflation still significantly away from the Fed target for the sixth consecutive year. This economic backdrop, together with the fresh spike in energy prices, will provide ammunition to the hawks in the FOMC this week.
While we do not expect a rate increase at this week’s meeting, we think that the bank’s communications will be unmistakably hawkish. The statement will once again be a short one, and will no doubt avoid the type of forward guidance that chair Warsh has shown a clear aversion to. But the accompanying communications will probably indicate to markets that hikes are coming should the Iran war drag on and oil prices remain around or above current levels for any significant period of time.
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