US
USD is holding on to this week’s gains, triggered by energy-shock risk aversion. The slump in bonds and stocks stabilized as the overshoot in crude oil prices stalled. Worrisomely, Iran has every incentive to keep the heat on ahead of the November 3 midterms and hurt Republicans. As such, any relief pullback in crude oil prices is likely to be shallow and short-lived.
For now, all eyes are on today’s FOMC decision (7:00pm London, 2:00pm New York). The FOMC is poised to deliver a 25bps hike to a target range of 3.75%-4.00% after five straight holds, marking its first hike since July 2023. Persistently above target US inflation and a stable labor market justify a rate increase.
Fed funds futures price in 94% odds of a hike today. As such, the vote split, updated Summary of Economic Projections, and Fed Chair Kevin Warsh’s press conference will guide the market reaction.
The swaps curve already implies almost 100bps of tightening over the next twelve months: 25bps today, another 25bps hike by year-end, and nearly 50bps by September 2027. This creates an asymmetric risk for USD with limited gains from a hawkish outcome, but greater downside from a dovish surprise.
A hawkish hike scenario would feature a unanimous or near unanimous vote for a hike, dots closer to market pricing, and/or Warsh signaling further tightening. That would lift USD and weigh on long term Treasury yields by reinforcing the Fed’s inflation fighting credibility.
A dovish hike scenario would feature a split vote for a hike, dots well below market pricing and/or Warsh framing the hike as insurance against inflation rather than the start of a sustained tightening cycle. That would weaken USD and keep long-term Treasury yields elevated.
In our view, the US economy does not warrant an aggressive tightening cycle. The slowdown in wage growth is disinflationary, and Fed policy is already somewhat restrictive against a nominal neutral rate of around 3.00%.
Ahead of the FOMC decision, US retail sales are expected to rebound in August (1:30pm London, 8:30am New York). Total nominal retail sales are seen rising 0.8% m/m vs. -0.6% in July in part due to higher prices. The policy relevant control-group sales - which exclude cars, gas, food services, and building materials – is expected at 0.5% m/m vs. -0.4% in July. That would be consistent with soft real consumer spending activity as headline CPI rose 0.4% m/m in August.
UK
GBP/USD is trading heavy, just above its 200-day moving average at 1.3455, while the selloff in gilts eased. UK August CPI report largely matched consensus but was hotter than the BOE’s projections. Headline CPI rose to a five-month high at 3.1% y/y (consensus: 3.1%, BOE projection: 2.8%) vs. 2.9% in July, driven by higher motor fuel inflation. Core CPI printed at 2.6% y/y (consensus: 2.6%) for a fourth straight month, and services CPI held at 3.4% vs. 3.4% in July (consensus: 3.5%, BOE projection: 3.3%).
The BOE is widely expected to keep the policy rate at 3.75% for a sixth straight meeting tomorrow given contained UK inflation pressures and ongoing labor market slack. In the next twelve months, the swaps curve implies 100bps of BOE rate hikes to 4.75%.
The aggressive pricing largely reflects the overshoot in energy prices. Unfortunately, the BOE cannot do much against this external energy shock. But they can prevent it from feeding into underlying inflation and inflation expectations. That means keeping policy sufficiently tight to curb demand, limiting firm's ability to pass higher energy costs into prices and reducing the risk of a wage-price spiral.
Nonetheless, the BOE may not need to tighten as much as markets expect. The UK economy is already operating below capacity, Bank Rate at 3.75% is near the top of the BOE’s estimated 2% to 4% neutral range, and fiscal policy will likely turn more restrictive. Bottom line: GBP is vulnerable to a dovish BOE repricing.
