In wating for the FED

May 4, 2022
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The greenback remains unstoppable and is keeping the pressure on the single currency with ...

The greenback remains unstoppable and is keeping the pressure on the single currency with just hours to go before the end of the Fed’s monetary policy meeting. Rate hike expectations are rising. Although the market initially anticipated a quarter-point hike, it is now expecting rates to rise by 50, maybe even 75, basis points. A half-point hike – the most likely scenario – would be the first since 2000 and would bring the policy rate into a fluctuation band of 0.75% to 1%. The Fed is also expected to announce that it will begin shrinking its balance sheet, which has grown steadily since the financial crisis as it activated its bond purchase plans to support the economy. But the Fed, like the ECB, is facing a delicate balancing act. On the one hand, consumer prices rose by a further 8.5% on an annual basis in March, and inflation shows no sign of abating. Thus, the US Employment Cost Index rose in the first quarter at a higher-than-expected rate and to a record level since it was introduced at the end of 1996. On the other hand, while the market expected the economy to post 1% growth in the first quarter of this year, it instead contracted by 1.4%. So, to break the inflationary spiral, the Fed needs to act quickly and decisively and at the same time avoid stunting economic growth. One thing everyone agrees on is that the Fed will not stop with today’s tightening: more will follow this year. The 30-day forward rate stands at 2.75% for the month of December. In another sign of tighter monetary policy to come, the yield on the 10-year Treasury note reached 3%, the highest level since late 2018. Therefore, if the contraction at the beginning of this year is a warning, the risk of recession will be greater next year when the Fed has raised rates several times, thus slowing down activity. In a sign that markets are nervous, US stock markets recorded their worst month since the start of the pandemic.

And as we said before, the European Central Bank faces the same dilemma. Inflation hit a new record high in April, at an annualised 7.5% as the war in Ukraine continued to put upward pressure on energy and other prices. And as expected, GDP growth in the euro area fell slightly from 0.3% to 0.2% in the first quarter. The German economy grew by 0.2%, French growth stagnated, and the Italian economy shrank by -0.2%. Also, the economic sentiment index for the euro area continued to deteriorate in April. Isabel Schnabel of the ECB believes that monetary policy needs to be adjusted to counter high inflation. “Talking is no longer enough, we need to act. From today’s perspective, a rate increase in July is possible in my view”, she said in an interview with German newspaper Handelsblatt.

The Reserve Bank of Australia surprised the markets by raising its base rate more aggressively than expected, from 0.10% to 0.35%. The market was expecting a 0.15% increase, but it got 0.25%. For a long time, the Bank gave the impression that there was no pressure to raise its benchmark rate. Governor Philip Lowe, now believes that the labour market is robust and should improve further in the future alongside the economy, allowing for such an adjustment. The Bank did not give any further indication as to the timing of future rate hikes but its more hawkish tone now has markets expecting an adjustment at every meeting this year.

The Japanese yen is down sharply against the dollar after the Bank of Japan’s decision to continue its ultra-accommodative monetary policy. The BOJ will continue to buy an unlimited amount of 10-year bonds to keep the yield below 0.25%.  It is thus going against the trend followed by the other main central banks, which are raising their rates or are planning to do so. Analysts are not, therefore, expecting a rate hike this year, which should keep the Japanese currency under pressure. The yen, which traded at 115 to the dollar on 3 January, is now trading at 130. The question the market is now asking is whether the central bank will intervene to support its currency. But it has rarely done so. The last interventions to prop up the yen took place 24 years ago. And back then, it was trading at 150 to the dollar. The last interventions to weaken the yen took place 11 years ago when it traded at 73.35 to the dollar on 30 December 2011.

Gold is also taking a beating from the dollar and the Fed’s upcoming policy. The ounce remains below USD 1,900.00 as the market fears an even-bigger-than-expected rate hike. A strong dollar and a rise in dollar earnings are the two main factors working against the price of the yellow metal, which not even runaway inflation can offset.