GBP weakens ahead of important BoE policy meeting

USD: Fed Chair Powell’s testimony triggers sell-off

The US dollar has continued to trade at weaker levels during the Asian trading session following yesterday’s sell-off. US dollar weakness has helped to lift EUR/USD back up to within touching distance of the 1.1000-level as the pair moves closer to the year to date high from April at 1.1095. The main trigger for yesterday’s US dollar sell-off was the semi-annual testimony on monetary policy from Fed Chair Powell to Congress. The content and the tone of comments from Fed Chair Powell were similar to following last week’s FOMC meeting. It has provided some initial relief for market participants who had feared that a more hawkish message could have been delivered to encourage US rate market participants to price in a higher probability of two more hikes this year. The absence of a more hawkish message yesterday leaves the US rate market comfortable to price in only one further hike at this stage. There are currently 17bps of hikes priced in by the next policy meeting on 26^th July and 21bps by the following meeting on 20^th September. The developments are consistent with our view that the US rate market will not move to price in more fully a second hike unless backed up stronger than expected US activity and inflation data in the comings months. We are sticking to our view that building evidence of disinflation pressures in the coming months will encourage the Fed to pause their rate hike cycle at the September FOMC meeting. Market participants will also continue watch closely for further evidence that the US labour market is beginning to weaken more in response to higher rates. Initial claims have moved higher in recent weeks and the latest release today will garner more market attention than is normal. It supports our outlook for further US dollar weakness this year. We recommended a new long EUR/USD trade idea in our FX Weekly report (click here) last week in anticipation that the US dollar would continue to correct lower and reverse last month’s gains.    

Looking at the comments from the semi-annual testimony in more detail, Fed Chair Powell stated that it “may make sense to move rates higher but to do so at a more moderate pace” which explains why the Fed did not hike rates this month for the first time during the current tightening cycle while signalling that they plan to raise rates tow more times this year. The decision not to raise rates this month gives the Fed more time to assess the incoming economic data before deciding whether to tighten policy further although the Fed has clearly signalled that it is not the end of the tightening cycle. We believe there is a higher risk of another hike in July unless there was a run of significant downside surprises from the US economic data flow in the month ahead. With regards to very tight labour market conditions, Fed Chair Powell expressed some optimism that the decline in the numbers of voluntary quits was a “really good sign”. Fed Chair Powell will now speak before the Senate later today although his comments are unlikely to be as market moving as yesterday.        

GBP HAS STAGED STRONG REBOUND SINCE LAST AUTUMN

Source: Bloomberg, Macrobond & MUFG GMR

GBP: Will the BoE meet expectations for a larger 50bp hike today?

Market attention will now turn to the policy update from the BoE today which has become even more important following the release yesterday of another significant upside inflation surprise in the UK. The pound initially rallied after the release of the UK CPI report yesterday but quickly gave back those gains. It has resulted in EUR/GBP rising back above the 0.8600-level as it moves further above last week’s low of 0.8518. Price action for cable has been more volatile which initially jumped to a high yesterday of 1.2802 and then falling to an intra-day low of 1.2691 before rising back to pre-UK CPI report levels later in the day as the US dollar weakened more broadly. While one should never place too much emphasis on one day’s price action, it was notable that the pound failed to strengthen further yesterday on the back of another adjustment higher for UK rates. The UK rate market has moved to almost fully price in the policy rate moving to a peak of 6.00% later this year which is well above expectations for the ECB and even Fed.

Yield spreads have moved sharply in favour of the UK this year and helped the pound to outperform, but the price action yesterday will start to raise questions over whether we are getting closer to the point where higher yields are no longer viewed as favourably for the pound. If the policy rate does move up to 6.00% and into much more restrictive levels it will increase the risk of a sharp slowdown/recession for the UK economy in the coming years. While that would help to slow inflation as the BoE would like, the negative impact on the UK economy could trigger a reversal of the bullish pound trend that has been in place since last autumn. Price action in the coming weeks/months will provide a better indication as  to whether a turning point has been reached for the pound. In the near-term, today’s BoE policy decision could also trigger a further correction lower for the pound if the MPC disappoints market expectations for a larger 50ps hike to regain with inflation fighting credibility. There are currently 38bps of hikes priced into the UK rate market ahead of today’s policy meeting. The BoE could though stick to the gradual path of 25bps hikes today but signal that it will assess in more detail the need for a larger hike in August  when the next Monetary Policy Report is released.    

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
SZ	08:30	SNB Interest Rate Decision	Q2	1.75%	1.50%	!!!
US	09:00	Fed Waller Speaks	--	--	--	!!
SZ	09:00	SNB Press Conference	--	--	--	!!!
NO	09:00	Interest Rate Decision	--	--	3.25%	!!
UK	12:00	BoE Interest Rate Decision	Jun	4.75%	4.50%	!!!
US	13:30	Initial Jobless Claims	--	260K	262K	!!!
US	14:55	FOMC Member Bowman Speaks	--	--	--	!!
US	15:00	Existing Home Sales	May	4.25M	4.28M	!!!
US	15:00	Fed Chair Powell Testifies	--	--	--	!!!

Source: Bloomberg