Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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FX Update: Tough task for Bank of England to look relevant today.
John J. Hardy
Chief Macro Strategist
Summary: The Bank of England will struggle to look relevant today, as it is forced to react to soaring inflation with a fifty basis point rate hike and possibly more large hikes to come, all while shielding its eyes on incoming recession risks. To boot, the Bank has promised to deliver a plan for balance sheet reduction, likely set to start later this year. Elsewhere, Europe’s energy crisis gallops on, Australia’s external surplus is soaring and JPY eyes recent pop in yields and US jobs report tomorrow.
FX Trading focus: Bank of England will struggle for relevance today. Watching for sterling turn lower.
The Bank of England is priced at over 80% odds to hike another 50 basis points at today’s meeting, with two further 50 basis point hikes half-heartedly priced for the following two meetings (market price for a total of 129 basis points through the next three meetings – 45 for today’s, 46 additional for Sep. and 38 more for the Nov. meeting). A couple of dovish dissenting voices are likely on concerns that the UK is headed into a recession and that accelerating the policy tightening is not the right medicine, while Governor Bailey seems happy to signal that concern while throwing up his hands at the lack of alternatives, given forecasts that inflation is set to reach above 10% in Q4. Besides any language that shifts the market’s lean on the size of future rate increases, watch for the indirect implications of any change to forecasts for economy (will the BoE explicitly forecast a recession and are inflation forecasts of sub-2% levels by 2024 maintained) as well as the signaling on reducing the balance sheet (the plan is supposedly for a £50-100 billion annual pace starting possibly after a vote in September). The event risk outcome from this BoE meeting run from indifference to slightly upside risk and somewhat larger downside risk for sterling. Have a hard time seeing the BoE coming with a significant hawkish upgrade relative to market expectations. Supposedly, forecast adjustments on inflation could see the market adjusting rate tightening expectations higher, but how likely is that as energy prices are below where they were at the BoE’s May forecasts and the BoE is likely looking for excuses to sit on its hands and await incoming data – a la the Powell Fed – as clouds gather on the horizon?
Chart: EURGBP
Sterling has traded firmly against the single currency since mid-June, largely in line with the Bank of England bolstering its hawkish credentials as it signaled the intent to hike more at coming meetings to counter the inflation threat. Today’s Bank of England is an interesting test of the Bank’s relevance and sterling, particularly in this most important of sterling pairs. Both the UK and the continent are in similar boats with a galloping energy crisis, but with the UK facing far more isolation and worse external deficits if the prospects for the winter darken, although the EU has the unique angle of a possible new existential crisis brewing in the wake of the Italian election – so far not priced with much fear in the options market. There is a bit of range left to work with down to 0.8200-50, while a reversal back above 0.8450 suggests this recent period of sterling out-performance is behind us should the Bank of England fail to gain more credibility on its guidance and balance sheet reduction plans.
Elsewhere, the very strong ISM Services survey yesterday at 56.7 (very confusing given counter-evidence of a sharp weakening in the S&P Global Services PMI) sparked a strong move higher in US yields and the US dollar, but one that was largely erased later in the day. Financial conditions remain very complacent and risk sentiment likewise, as some of the more speculative sectors of the US economy are outperforming by a wide margin on this squeeze higher, volatility remains low and credit spreads are tightening. Another strong drop in oil prices does help to ease stagflationary concerns, but oil prices can only fall from here on a coming hard landing due to a demand collapse. There is simply no sustainable Goldilocks narrative here for markets and the economy – particularly for Europe unless there is an immediate cessation of the war in Ukraine and a resumption of natural gas deliveries from Russia. Adding to Europe’s woes are the dire outlook for winter power prices, not just from the 80% reduction in gas coming through the Nord Stream pipeline, but also as France has been forced to take a large chunk of its nuclear power capacity offline due to corrosion issues, possibly unable to resume operations at. Temporarily, France and Germany are beset by near term risks of power delivery as the Rhine river is running at record lows, making coal shipments by barge difficult, and the rivers in France are too hot for cooling some of its nuclear plants, requiring further shutdowns. Watching for any new turn lower in risk sentiment to freshen up the EURUSD bear move and a challenge of parity and beyond once the US employment tomorrow is out of the way.
Table: FX Board of G10 and CNH trend evolution and strength.
The momentum shift in JPY is incredible – status refresh will come on the other side of the US jobs report tomorrow, as with the USD itself on the combination of the direction of US yields and risk sentiment (yields up, sentiment down is the high-octane combo for USD strength). Watching whether BoE today sparks any new GBP impulsive move. Surprised that NOK and CAD haven’t lost more altitude on this latest drop in crude oil prices.
Table: FX Board Trend Scoreboard for individual pairs.
Things have gone stale in many USD pairs, with USDJPY a bit chaotic on the huge swoon followed by the tremendous bounce. AUDNZD has yet to bite lower after its trend reversal into negative – no follow through eventually means no trend – awaiting status there.
Upcoming Economic Calendar Highlights (all times GMT)
- 1100 – UK Bank of England Rate Announcement
- 1130 – UK Bank of England Governor Bailey press conference
- 1130 – US Jul. Challenger Job Cuts
- 1230 – US Jun. Trade Balance
- 1230 – Czechia Repurchase Rate Announcement
- 1230 – Canada Jun. Building Permits
- 1230 – US Weekly Initial Jobless Claims
- 1600 – US Fed’s Mester (Voter) to discuss economic outlook
- 0130 – Australia RBA Statement on Monetary Policy
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