Bond, stock and FX markets have all experienced some big moves today on the back of a deluge of central bank meetings and some weak US economic data, which weighed heavily on the dollar. The question now is whether today’s events will prove to be a watershed moment for markets with the pound making its long over-due recovery, the Turkish lira spurring a broad-based recovery in the EM FX space, and if the dollar has had its moment in the sun?
Below we take a look at 4 events from today and give our view:
ECB meeting: The ECB may have revised down its growth forecasts for 2018 and 2019; however, ECB President Mario Draghi did his best to downplay the revision and the threats posed to EU growth from turmoil in Turkey and a no-deal scenario in Brexit negotiations with the UK. Overall, the ECB’s mandate is to manage inflation, and this is where Draghi and co. believe that pressures are rising, albeit at a slow pace. The ECB needs to ensure that it sticks to its mandate, which could mean that they become less tolerant of inflation in the coming months. Due to this, even with the growth downgrades, the ECB remains on track to end its Asset Purchase Programme at the end of this year, which was considered “hawkish” by the market. Combined with the decline in US CPI (see below) the euro reacted positively to this news and rose to its highest level so far this month. At the time of writing, resistance around the 100-day sma level at $1.1682 was thwarting EUR/USD, and today’s 80-pip move in EUR/USD has been one of the most volatile trading days for this pair in months.
Overall, this should be positive for the euro in the short term, however, we will need to see a sustained rise in German bond yields if EUR/USD is to test the 1.20 highs from May. Considering the ECB is still loath to raise interest rates until at least next summer, yield support may not be forthcoming, which could limit euro upside in the medium-term.
Bank of England: As we mentioned in our previous note, the BOE’s outlook was clouded by what it considers increased levels of Brexit uncertainty due to the political atmosphere in Westminster. This initially weighed on the pound, however, things started to change for the pound when the US CPI data was weaker than expected.
Although the euro had a larger move vs. the dollar compared to the pound in percentage terms, GBP/USD broke through a key short-term resistance level at $1.3050 on Thursday, which could trigger a move back to $1.3200. Thus, the upswing for the pound on the back of today’s move could last for longer compared to the upside for the euro, and at the time of writing EUR/GBP had started to give back some gains from earlier this afternoon.
Interest rate probabilities are also worth watching. Expectations for a February rate hike from the BOE actually rose on the back of today’s events, with the market now pricing in a 25% chance of a hike to 1% in February, up from a 22% chance last week. This may seem like a small increase, but if we see further positive economic data from the UK then expectations could increase further, adding more support to the GBP recovery.
While we continue to think that the key driver of the pound is likely to be politics until we know the outcome of the EU/UK summit due in November, it has been refreshing to have the GBP move mostly on the back of economic fundamentals for a few days. We think that GBP/USD may recover into the end of the week, with $1.3200 a level that could attract some sellers. What the pound does next week could be determined by the headlines in the Sunday papers.
Turkey: more of the same, please
As we have mentioned already, the market is likely going to want to see further rate rises from the CBRT and more signs that the central bank is independent and is willing to override the economic wishes of President Erdogan, like we saw today. However, we have been impressed with the TRY’s ability to hold onto gains after the upswing in the TRY on the back of today's larger than expected rate hike. As long as we don’t hear any negative political comment regarding the rate hike from the President’s office or any suspicious resignations from the CBRT, then this recovery could have some legs.
The move in the lira has cast a positive glow over the broader EM FX space, with the SA rand, Russian ruble and Chilean and Mexican pesos all posting sizable gains vs. the USD today. However, the fact that the EM space continues to move in a block is worrying to us: it suggests that it is not only domestic factors that is driving the volatility in the EM space, and if we are to see a sustained recovery in EM asset prices then we may need to see other factors come into play such as a reduction in trade tensions and geopolitical risk. Thus, while we are impressed with today’s move in the TRY, we are not sure that it will last more than a few days; however we are happy to be wrong on this one!
US economic data surprise:
The other big driver of the markets today was the CPI miss in the US. Annual prices slipped to 2.7% from 2.9%, and core prices slipped to 2.2% from 2.4%. With US interest rates now sitting at 2%, this is the highest real interest rate (interest rates – inflation rate) since April, and on a core basis, it is the highest real rate since March. As real interest rates rise, this should be, in theory, dollar positive.
Of course, it all depends on how this month’s data will impact the thinking at the Federal Reserve, and we are not sure that the Fed will pay too much heed to the August numbers, the main reason being the surge in oil prices this month, which should put upward pressure on the CPI figure for September when it is released next month.
Interest rate expectations for a rate hike later this month are virtually unchanged, with the Fed funds futures market pricing in a 99.8% probability of a hike. Expectations also remain high for a further rate hike for December, which suggests to us that the decline in the dollar could be based on positioning, and if the dollar index can remain above the 200-day sma at 94.44 then we may see a slowdown in dollar weakness into the weekend.