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Will the BoE follow suit and raise by more than normal?

Sterling made gains against both the Euro and US dollar last week following European gas supply issues and the lowering of the US interest rate curve. In terms of data, although the second tier softened, it presents ongoing questions about the economy’s ability to weather future hikes. The UK CBI retail sales index recovered marginally to -4 for July from -5. This figure was slightly stronger than market expectations of -10. In the meantime, Liz Truss and Rishi Sunak continue campaigning with Truss, the bookies’ favourite, to win the race to become the new Conservative leader.

Following the recent interest rate decisions from the ECB and FOMC, it is now the turn of the Bank of England. The BoE will release its updated monetary policy on Thursday. It is heavily favoured to raise by 50 basis points (87% probability). However, there are growing murmurs that we could only see a 25 basis point hike. At its update in June, the MPC paved the way for this by replacing its previous forward guidance with a more flexible commitment. It highlighted its responsibility to stay “alert to indications of more persistent inflationary pressures” and to “act forcefully in response.”

Since then, we saw inflation push higher, forecast to continue higher. In addition to the policy rate announcement, we anticipate the BoE’s updated forecasts again to highlight that market-based measures of interest rate expectations. The BoE will probably lift its expectation again for the near-term peak in inflation, to around 12% (in October), following the removal of another energy price cap plus the ongoing uncertainty resulting from Ukrainian and Russian tension. The cost-of-living crisis will likely affect the BoE’s growth forecasts for 2022 and 2023, downgrading figures.

US Payrolls data to provide direction on Fed’s Policy outlook

The US dollar dropped last week for the second consecutive week, the first back-to-back weekly decline for the currency since the middle of May. The catalyst was of little surprise following Thursday’s announcement that the US economy contracted for a second successive quarter in Q2 of 2022. The news followed the Federal Reserve’s announcement to raise interest rates by 75 basis points, which means that policy rates are now between 2.25% – 2.50%.

Crucially, the Fed’s statement and policy update acknowledged that we are beginning to see signs of economic weakness. Nonetheless, policymakers re-asserted that inflation remains the Fed’s primary concern. Following the comments, markets’ expectations for longer terms and higher rates fell sharply, leading to higher volatility across the US bond market. The report signals that we’re going to see a relatively more dovish Fed moving forward, whereby even if there are further hikes, it’s unlikely we would see the 75-bps increase.

This week’s standout economic data release comes from the July labour market report, due on Friday. The labour market is widely considered a fundamental condition for the Fed’s pace of policy tightening. The July and August reports will be particularly significant now that we see evidence of service sector weakness. June payrolls posed more questions than answers, presenting the weakest number this year at 372k. It was still much higher than expected, with the unemployment rate steady at 3.6%. Notably, weekly jobless claims rose for the past three months. The rise in jobless claims appears to be the first sign of US labour market weakness, increasing the focus on the headline figure on Friday.

Elsewhere this week, investors will review several critical indicators, including the ISM reports for Manufacturing and Services, on Monday and Wednesday. Meanwhile, Fed presidents Evans and Mester will speak later in the week ahead of the nonfarm payrolls report and unemployment rate on Friday.

GDP remains healthy, easing concerns about the economy.

Recession fears and the ever-present energy crisis scared investors. The euro faces the stress of heavy selling at the start of this week. Current bond market fragmentation presents a risk, while peripheral bond yields have not yet widened relative to their core counterparts. The ECB began to hike interest rates this month. However, a weak growth outlook presents the question of how much policymakers can achieve with a shift in policy outlook. Russia announced it is reducing gas supplies through its Nord Stream 1 pipeline to only 20% capacity. This announcement stoked fears that Eurozone growth will slow further, signalling that energy inventories will not be stockpiled sufficiently before winter.

The second half of the week saw a fight back from the region as economic data posted positive readings. The GDP data particularly supports the euro, given the increase in negative sentiment towards the Eurozone. Eurozone GDP increased 0.7% quarter-on-quarter in the second quarter of 2022, exceeding expectations of 0.2% and improving on the first quarter growth figure of 0.6%. Eurozone CPI inflation meanwhile increased 0.1% month-on-month in July, exceeding expectations for a decline of -0.1%, which is cooling from the previous month’s 0.8% rise. The annual inflation rate stood at 8.9% in July, higher than expectations for 8.6%. The data aligns with the European Central Bank’s intent of normalising interest rates. As a result, expectations of a second consecutive 50 basis point hike in September will likely persist.

This week, economic data is light in relevance. On Tuesday, the market will pay attention to the service sector data from Italy and Spain to articulate if tourism will bounce back. The market will also watch industrial production figures on Friday.

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