Multiple central bank decisions and a grim financial backdrop

This week, central banks are in focus. Both the Federal Reserve and the Bank of England are expected to raise interest rates when they meet on Wednesday and Thursday, by 75 basis points and 50 basis points, respectively. Financial markets are rattled to say the least, Wall Street recorded the biggest weekly drop in months, the S&P 500 fell 4.8%, while the Nasdaq dropped more than 5%. The plethora of central banks announcing their rate decisions, the Bank of Japan will also join the chorus, could inject further volatility into financial markets. 

Symbolic Fedex sends shiver down traders’ spines 

Looking at last week’s stock market performance in more detail, the driver of the decline for US and global stocks was firstly, stronger than expected US headline CPI and secondly, a warning from Fedex, the shipping company, that it would close offices, freeze hiring and park aircraft due to a sharp drop in package shipping volumes, which saw the stock lose more than a fifth of its value. The company reported weaker than expected Q2 results and withdrew its full year guidance, after warning of a deteriorating macroeconomic backdrop. Fedex is symbolic of the wider economy, when transport companies start to perform badly it is usually a warning sign for other sectors. This is particularly concerning when we are reaching the end of Q3, with expectations for earnings season rapidly being revised down. In the first half of the year, companies did a stellar job of passing costs onto their consumers. However, with inflation remaining sticky, this dynamic cannot last forever, so underlying conditions for equities across the west have deteriorated. Therefore, stocks sold off so sharply last week. What they do next week is very contingent on the outcome of the central bank meetings, especially the Fed meeting. 

Looking ahead to the Fed 

There is currently an 82% probability of a 75 bp rate hike from the Federal Reserve this week, with a small chance of a 100 bp rate hike. Not that long ago, some corners of the financial markets were looking for the Fed to pivot away from larger rate hikes, and slow down to 50bp rate hikes from here. However, after last week’s CPI report, there is now no chance of a 50bp rate hike this week, according to trading on the Fed Funds Futures market. We do not think that the Fed will hike by 100bp on Wednesday, for a few reasons: 1, they don’t like to surprise the market, 2, there are clear signs of an economic slowdown and 3, while some areas of inflation are proving to be sticky, inflation expectations in the US have turned lower. The 5-year 5-year forward inflation rate, has fallen to 2.24%, which is within hitting distance of the Fed’s 2% target rate. Thus, we believe that the Fed will deliver some “good” news on Wednesday: it won’t hike rates by 100bps. 

The good news from the Fed will be fleeting 

Unless the Fed wants to lose all credibility, then the good news at this meeting will be fleeting. Instead, the Fed will need to impress on the market that it means business when it comes to fighting inflation. With the inflation rate proving to be stickier than expected, especially core inflation, then it will need to elongate its rate hiking cycle. By the end of 2023, the Fed Funds futures markets expects interest rates in the US to have risen to 4%-4.25%, which is 1% higher than what was expected a month ago. Thus, the prospect of a Fed pivot is now a 2024 event, not a 2023 event. In trading terms, this means that in the short to medium term, unsurprisingly, we continue to like the dollar. After GBP/USD’s rout last week, which saw it fall to $1.1430, momentum remains to the downside. The sharp decline in cable could slow this week, but ultimately if the UK goes on a massive spending binge at this week’s mini budget on Friday, then the path for the pound is lower. 

Will the euro fall? 

EUR/USD’s path has been much smoother than the pound’s in recent weeks, and it continues to trade sideways after breaking above the $1.0260 level. However, we believe that the euro’s time will come. Parity will still loom, it could be triggered by this weekend’s Italian elections, that threaten to disrupt the status quo in the Eurozone. Added to this, the technical picture for the dollar looks attractive if the dollar index remains above its 50-day moving average around 108.0. The dollar is also likely to be supported this week by Monday’s trading action in US government debt, which saw Treasury yields jump to their highest levels in a decade. The 10-year yield jumped to 3.5% for the first time since 2011, while the 2-year yield jumped to a 15-year high of 3.94%. This is worth watching, if the Fed’s dot-plot survey of interest rate expectations, shows the terminal rate rise above the 4%-4.25%, as the Fed tries to burnish its inflation fighting credentials, then short term yields could surge, sending the yield curve further into inversion, and thus recession, territory and causing the dollar to soar. 

BOE could be stymied by the Chancellor 

UK markets have been closed today as a mark of respect for the funeral of Queen Elizabeth II. While the death of the monarch and the ascension to the throne of King Charles III, won’t move markets, the delay to the BOE meeting, which will now take place this week, could stem the outflows from the pound, if the BOE does as expected and hikes rates by 50 bps. We expect any decline to be short lived, as the hawkish work of the BOE is likely to be unravelled by a profligate chancellor delivering his first budget on Friday. We’ll fill you in more on that later this week.