Sterling Pounded as BOE Forecasts U.K. Recession

May 05, 2022

Win Thin

The Fed hiked rates 50 bp, as expected; more aggressive market pricing for rate hikes suggests the initial dovish take on Powell was wrong; U.S. yields are rising again; data yesterday came in soft; Treasury cut its quarterly refunding plans; Chile is expected to hike rates 100 bp to 8.0%.
BOE hiked rates 25 bp to 1.0%, as expected; eurozone data came in weak; ECB tightening expectations remain subdued; Norges Bank kept rates steady at 0.75%, as expected; Czech Republic is expected to hike rates 50 bp to 5.5%; Poland is expected to hike rates 100 bp to 5.5%
Caixin reported weak April China services and composite PMI readings

The dollar is recouping its post-FOMC losses. DXY is trading back near 103 as markets reassess their dovish take on the Fed. The euro remains heavy after failing once again to break above $1.06. USD/JPY remains stuck below 130 but we continue to look for a test of the 2002 high near 135.15. Sterling is underperforming after the BOE signaled a recession is on the way, trading back near $1.2465 after a brief foray above $1.26. Between lingering risk-off impulses and the recovery in U.S. yields, we believe the dollar uptrend remains intact. Any post-FOMC profit-taking in the dollar should be viewed as a buying opportunity.

AMERICAS

The Fed hiked rates 50 bp, as expected. It also announced that Quantitative Tightening will begin June 1 at a pace of $47.5 bln per month for the first three months ($30 bln in USTs and $17.5 bln in MBS). The cap would then double in September to $95 bln per month ($60 bln in USTs and $35 bln in MBS). There will be no new forecasts until the June 14-15 FOMC meeting. WIRP suggests a 50 bp hike is fully priced in then as well as at the July 26-27 meeting. Another 50 bp hike at the September 20-21 meeting is almost fully priced in, with the Fed then expected to downshift to 25 bp hike at the November 1-2 and December 13-14 meetings. All told, the swaps market is now pricing in a terminal Fed Funds rate near 3.75% over the next 12 months, up from 3.25% at the start of the week.

The more aggressive market pricing for rate hikes suggests the initial dovish take on Powell was wrong. We concur. Yes, we were surprised that he seemed to rule out a 75 bp hike as we believe the Fed should always keep all options open. Yet a 75 bp hike was never a serious option to us. Powell admitted that with regards to the 2% inflation target, “Yes, there may be some pain associated with getting back to that.” Powell invoked former Fed Chair Volcker, saying he had the courage to do what he thought was right. Powell said that tightening policy isn’t going to be pleasant, adding that there is “plenty to be done” in dealing with excess demand. He also said that it’s possible that the Fed moves policy to restrictive territory. Make no mistake, the Fed is in the early stages of what we believe will be a very aggressive tightening cycle. Fed speakers will fan out in the coming days and we expect them to maintain a hawkish stance. Williams, Kashkari, Bostic, Bullard, Waller, and Daly all speak tomorrow.

U.S. yields are rising again. The 10-year yield traded as low as 2.90% yesterday but is currently bank near 2.96% and just below the 3.01% cycle high from earlier this week. Similarly, the 2-year yield traded as low as 2.60% yesterday but is currently back near 2.70% and moving back towards the 2.85% cycle high from earlier this week. This uptrend is likely to continue as U.S. inflation continues to run hot and the Fed continues its aggressive tightening cycle. Of note, the 2-year interest rate differentials have swung back in the dollar’s favor after a brief corrective phase last week. In particular, the spreads with Japan (277 bp) and the U.K. (112 bp) continue to make new cycle highs, while the spread with Germany (245 bp) is lagging a bit. All should continue to rise.

Data yesterday came in soft. ISM services PMI came in weaker than expected. Headline came in at 57.1 vs. 58.5 expected and 58.3 in March. Looking at the components, employment fell to 49.5 vs. 54.0 n March, while prices paid rose to a record 84.6 vs. 83.8 in March. Elsewhere, ADP reported private sector jobs rose 247k vs. 383k expected and a revised 479k (was 455k) in March. Clues point to a soft NFP number tomorrow, where consensus is currently at 380k vs. 431k in March. The Fed will be watching for signs of further weakness in the economy but for now, it is clearly committed to bringing inflation down and so tomorrow’s data will have little impact on Fed policy. April Challenger job cuts, Q1 nonfarm productivity and unit labor costs, and weekly jobless claims will be reported today.

The U.S. Treasury cut its quarterly refunding plans. Treasury cut its planned sales of long-term debt for a third straight quarter to $103 bln, down $110 bln in February. $45 bln of 3-year notes will be sold next Tuesday, $36 bln of 10-year notes will be sold next Wednesday, and $22 bln of 30-year bonds will be sold next Thursday. Treasury said that “additional reductions in future quarters may be necessary depending on future developments in projected borrowing needs.” Lastly, it said that “Given Treasury’s desire to stabilize the share of TIPS as a percent of total marketable debt outstanding and continued robust demand, Treasury will continue to monitor TIPS market conditions and consider whether subsequent modest increases would be appropriate.”

Chile central bank is expected to hike rates 100 bp to 8.0%. However, a couple of analysts polled by Bloomberg see 75 and 150 bp moves. At the last meeting March 29, the bank delivered a dovish surprise with a 150 bp hike to 7.0% vs. 200 bp expected. The swaps market is pricing in another 175 bp of tightening over the next 3 months that would see the policy rate peak near 8.75%. April CPI data will be reported Friday and headline is expected at 10.1% y/y vs. 9.4% in March. if so, it would be the highest since September 1994 and further above the 2-4% target range. As such, we see risks of a hawkish surprise today.

EUROPE/MIDDLE EAST/AFRICA

Bank of England hiked rates 25 bp to 1.0%, as expected. However, the messaging was very mixed. Three MPC members voted for a 50 bp hike, with rest voting for 25 bp. However, two felt that guidance for more hikes was “not appropriate.” At the last meeting March 17, the vote to hike 25 bp was 8-1, with Cunliffe dissenting in favor of no hike. The 2022 inflation forecast was raised to 10.25% from 5.75% in February, while the 2023 forecast was raised to 3.5% from 2.5% in February. More importantly, the 2023 GDP forecast was cut to -0.25% from 1.25% in February. With a recession looming, did three MPC members really vote for a 50 bp hike? This tells us that the BOE is rushing headlong into a policy mistake and that is very sterling-negative. Looking ahead, the swaps market is still pricing in 150 bp of tightening over the next 12 months that would see the policy rate peak near 2.5%. This seems wrong if the U.K. really is headed for recession.

Eurozone data came in weak. Germany reported March factory orders. Orders were expected at -1.1% m/m but instead plunged -4.7% vs. a revised -0.8% (was -2.2%) in February. As a result, the y/y rate fell to -3.1% and was the first contraction since September 2020. German IP will be reported tomorrow and is expected at -1.3% m/m vs. 0.2% in February, but there are clear downside risks. Germany is the engine of the eurozone economy and recent signs point to continued weakness in Q2 after it barely grew at all (0.2% q/q) in Q1. However, there is weakness elsewhere as France reported March IP at -0.5% m/m vs. -0.2% expected and a revised -1.2% (was -0.9%) in February. Here, the y/y came in at 0.1% y/y and is clearly teetering on the brink of contraction.

ECB tightening expectations remain subdued. WIRP suggests odds of liftoff June 9 are now around 20% vs. 30% at the start of this week and 40% at the start of last week, while liftoff July 21 remains fully priced in. The swaps market is now pricing in 150 bp of tightening over the next 12 months, with another 50 bp (vs. 75 bp) of tightening priced in over the following 12 months that would see the deposit rate peak near 1.5% vs. 1.75% at the start of last week. While this still seems too aggressive to us, at least markets are recognizing that 1) eurozone inflation may be peaking and 2) the risks to growth are mounting.

Norges Bank kept rates steady at 0.75%, as expected. At the last meeting March 24, the bank hiked rates 25 bp to 0.75%, as expected. Today, the bank reaffirmed that a hike at the June 23 meeting is “most likely” and noted that “If there are prospects of persistently high inflation, the policy rate may be raised more quickly than indicated by the policy rate forecast in the March Report.” That rate path suggested a longer, greater tightening cycle ahead as the bank saw the policy rate peaking near 2.5% in 2024 vs. 1.75% previously. New macro forecasts and an updated rate path will be released at the June 23 meeting. Swaps market is pricing in 150 bp of tightening over the next 12 months followed by another 25 bp over the following 12 months that would take the policy rate up to an expected peak near 2.5%.

Czech National Bank is expected to hike rates 50 bp to 5.5%. At the last meeting March 31, the bank delivered the expected 50 bp hike to 5.0%. Since then, March inflation came in at 12.7% y/y, the highest since May 1998 and further above the 1-3% target range. The swaps market is pricing in another 75 bp of tightening over the next 12 months that would see the policy rate peak near 5.75% but we see upside risks.

National Bank of Poland is expected to hike rates 100 bp to 5.5%. However, a few of the analysts polled by Bloomberg look for smaller cuts of 50 or 75 bp. Minutes to the April 6 meeting will be released Friday. At that meeting, the bank delivered a hawkish surprise with a 100 bp hike to 4.5% vs. 50 bp expected. Since then, April inflation came in at 12.3% y/y, the highest since December 1997 and further above the 1.5-3.5% target range. As such, we see risks of a hawkish surprise today. The swaps market is pricing in another 150 bp of tightening over the next 12 months that would see the policy rate peak near 6.0% but we see upside risks here as well.

ASIA

Caixin reported weak April China services and composite PMI readings. Services plunged to 36.2 vs. 41.0 expected and 42.0 in March, which dragged the composite PMI down to 37.2 vs. 43.9 in March. this is much worse than the official PMI readings, where the composite PMI came in at 42.7 vs. 48.8 in March. The economy is clearly staggering from Xi’s COVID Zero policy. While policymakers have pledged more stimulus, it is unlikely to be very effective until the hard lockdowns have ended. Given the nature of the current wave of infections in China, we do not think the mainland economy will experience the V-shaped recovery that we saw back in 2020 despite official pledges of more stimulus.

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