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Can UK policy and MPC halt the slide in Sterling?

Last week, sterling remained on the backfoot amidst ongoing US dollar strength whilst the UK’s economic backdrop remains somewhat challenging. Front and centre, the “cost of living crisis” persists, which threatens to plunge the UK into a deeper recession than predicted and weaken the sterling simultaneously.

So far, the challenges the UK faces hindered the BoE from raising aggressively, with both the ECB and the FOMC expected to raise rates by 75 basis points compared to the UK’s central bank of 50. Capital Economics, an independent research provider, said sterling on a trade-weighted basis will likely depreciate by a further 5% by the end of 2022 and to 1.05 against the US dollar by mid-2023.

Friday saw the deadline for the Conservatives to submit their ballot papers for the party’s next leader. It will be announced today who that is with the next PM to be formally installed on Tuesday. The market was heavily pricing in Liz Truss. It will wait with bated breath to see what measures will be introduced to help with the ongoing crisis. 

Looking to the week ahead, the market will focus on politics and the MPC testimony. Amidst the current backdrop, economic data may be largely ignored but includes the final reading of the Services PMI (Mon), the Construction PMI (Tue) and the BoE/Ipsos inflation attitudes survey (Fri). The BRC retail sales (Tue) and RICS housing (Thu) reports are also due.

On Wednesday, BoE Governor Andrew Bailey will appear before the Treasury Committee, Huw Pill (Chief Economist), and external MPC members Silvana Tenreyro and Catherine Mann. They will inevitably be questioned on the decision in August to raise interest rates by 50bp to 1.75% and on the outlook for rates and the economy, including inflation.

Dollar rises to the highest level in two decades

Last week we saw the US dollar continue to make gains. The Dollar index (US Dollar vs a basket of currencies) reached its highest level since 2002. The move higher is a symbolic move following FOMC Chair Powell’s comments, signalling further hikes in the future. Last week, economic data was positive, which continued the dollar’s momentum. The ISM non-manufacturing showed that service sector activity accelerated faster than expected for July.

On Friday, the headline jobs number showed that Nonfarm payroll generated 315,000 versus the 300,000 expected, following a downwardly revised increase of 526,000 in July. The unemployment rate, meanwhile, rose to 3.7% from 3.5%, but the uptick can be attributed to a jump in the participation rate which climbed to 62.4% from 62.1%. This was enough to signpost a softer landing for the economy than previously thought. As a result of the last couple of weeks, we saw the probability of a 75 basis point hike this month increase to 75% probability.

Looking ahead, it is a quieter week with a bank holiday on Monday for Labor day. The market will closely follow remarks made by Fed Chair Powell in Thursday’s speech. They will look for clues of reinforcement of the messaging at Jackson Hole or if he believes the market misinterpreted it. 

Will the ECB raise by 75 basis points?

The single currency remains vulnerable to the US dollar whilst making gains against the sterling. The European central bank consumer expectations survey had positive outlooks on perceived inflation over the next 12 months remaining at 5%. Expectations for economic growth were shown to have declined, and in line with these expectations, consumers anticipate unemployment to rise. However, EUR/USD rates remained relatively steady.

European Commission President Ursula von der Leyen said from a summit in Slovenia this week that electricity costs have been lifted needlessly by the price of natural gas. Brussels will look to reform the power market in the early months of next year. Inflation reached a new historic high last month (9.1%) and was greater than anticipated by economists.

This week’s primary focus will be Thursday’s ECB interest rate decision. The ECB will likely raise interest rates again after lift-off at their last meeting in July when they hiked by more than expected (50bp), bringing the deposit rate to 0% from -0.5%. This time around, the debate on the Governing Council seems likely to shift to whether to raise policy interest rates by 50bp or a record 75bp. The probability of a 75-basis hike is currently 90%. The market will be keen to articulate the evolving interest rate path, especially with the evidence pointing to Eurozone GDP growth coming to a near standstill and the ongoing gas supply issues. 

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