Despite rising Gilt yields and steeper pricing of the Bank of England’s rate path in money markets, the pound struggled against the dollar in yesterday’s session. Arguably, most of the repricing in the rates space was reflective of the move in US markets and limited liquidity, suggesting that the 125bp worth of rate hikes implied by September in money markets isn’t necessarily reflected in other UK assets. Even on the off chance the connection remained, FX markets are fully aware that the Bank of England would only have to quickly reverse such hikes if they matched market expectations as the UK economy undoubtedly spirals into a recession in the following months. The current suppressed levels in the pound are reflective of both of these dynamics. Trading just north of yesterday’s 2-year low, GBPUSD currently reflects a substantial stagflation risk for the UK economy, while some political risk is also embedded into the price. This morning, the pound is trading up a fifth of a percentage point against the dollar, largely due to the more constructive market backdrop at the European open. Some positive developments in the UK labour market, as denoted by today’s release of April’s jobs report, have also stimulated minor GBP gains, but even the positive surprise in the net employment increase was undercut by an uptick in the unemployment rate from 3.7% to 3.8% and still weak real wage growth. This week’s data perfectly captures the UK macroeconomic backdrop of squeezed real household incomes, which is dragging people back into the labour market and reducing wage pressures at the margin, amid a stagnant growth backdrop. The Bank of England will be hard-pressed to continue hiking against this macroeconomic backdrop in our view, and we expect to see dissents on either side of the consensus to increase rates by 25bps as the hawks see a limited opportunity to bring inflation expectations down and the doves prioritise the slowing demand outlook.
The single currency wasn’t just hit by rising US Treasury yields and a stronger dollar yesterday, but also an explosion in peripheral bond spreads which historically weigh on the currency. With US Treasury yields marching aggressively higher, European bond traders were forced to match the move. The German 2Y yield climbed almost 20bp on the day to trade at levels last seen in 2011, but the riskier Italian debt took a much bigger hit. The 2Y BTP yield rose some 34bp on the day, while the back-end of the curve also rose 26bp. The differentials between German and Italian debt are now entering territory that will begin to cause concern among some members within the ECB’s Governing Council, begging the question as to when they will come out and announce their plan to reduce market fragmentation beyond highlighting the flexibility in PEPP maturities. Today, Isobel Schnabel has just that opportunity if the ECB decides, as the executive board member is scheduled to speak at 18:00 BST. With the Fed set to slam on the brakes again at tomorrow’s meeting, the abundance of ECB speakers scheduled to speak tomorrow isn’t surprising. The central bank may try and massage market concerns in the short-term, but they will ultimately need to present an answer for markets that will only continue to widen rate differentials in the eurozone until inflation starts to climb down.
The US dollar posted a strong rally on Monday, with the broad dollar DXY index closing the day up over 0.8% and touching a fresh 20-year high. Pricing of the Fed’s next policy move in rates markets caused the damage not only in FX markets but also in equities as the probability of the Fed raising rates by 75bps on Wednesday jumped to 93%, up from just 10% prior to Friday’s CPI report. The latest inflation data didn’t just impact pricing for the Fed’s next meeting, but also subsequent meetings this year as overnight index swaps now price a year-end rate of 3.66%, up 74bps from pre-CPI levels, while the Fed’s implied terminal rate now sits north of 4% for next year. The repricing in money markets occurred in tandem with that in bond markets. The 2-year Treasury yield catapulted 28bps higher, adding to Friday’s 24bps rally, while the 10-year struggled to keep pace with just a 30bp rally over the two days. Ultimately, this caused a further flattening in the yield curve, with the 2Y-10Y spread this morning trading flat. Inversion of the Treasury curve at these tenors will be closely watched, mainly due to its historic accuracy at pre-empting recessions. Pricing of a more aggressive tightening cycle by the Federal Reserve, and future growth concerns incited by this tightening cycle, weighed on equities yesterday as the S&P500 dropped 3.88% to enter a technical bear market while the NASDAQ fell over 4.5%. Markets this morning are trading in a bit more of a sanguine nature as some of yesterday’s excessive adjustment is retraced. European and US equity futures trade in the green, while the dollar is sustaining losses. In the Treasury market, bond traders are paring some of yesterday’s price action, with most of the adjustment occurring at the front-end of the curve as the idea of inversion is weighed. The spread currently sits at just 3bps. In tandem with the repricing in rates markets yesterday, sell-side analysts increased their calls for the Federal Reserve to hike by 75bps at tomorrow’s meeting, with some suggesting that a 100bp move isn’t off the table as the Fed weighs a “Volker moment”. However, given this is just one CPI release, we don’t think the Fed’s decision is as clear-cut as markets necessarily suggest and believe the Fed is still likely to underdeliver on market expectations. This isn’t limited to the actual move itself but also the central bank’s forward guidance via the dot plot. Even if the Fed did hike by 75bps, the 2022 median dot is likely to fall short of the 3.66% year-end pricing, which suggests a cumulative 266bps increase spread over 5 meetings. In this sense, the dollar’s decline from yesterday’s multi-decade high may just be starting.
Momentum from Friday, combined with spill over from the big moves in US markets weighed on CAD yesterday. The most important factor feeding into CAD price action was the continued widening of the US-Canada interest rate differential, fuelling the loonie sell-off. Canadian rates shifted up in parallel, with the 2Y rising 16.4bps and the 10Y up 16.9bps, in contrast to the US yield curve’s bear flattening, which suggests that US yields dragged Canadian rate expectations higher but didn’t say anything meaningful about Canadian growth prospects. Canadian equities acted as another headwind pushing down CAD, with the TSX falling 2.6% on the day. This morning, with pressure from US Treasuries easing ahead of the North American open and equity futures pointing higher on the day, the loonie is slowly chipping away at yesterday’s losses as it trades 0.14% higher. However, market moves today are likely to be more muted as traders position themselves ahead of tomorrow’s monumental FOMC meeting.