Bulls Turn Cautious Ahead Of Federal Reserve’s Decision
Bracing for Pound depreciation
The consensus among economists has recently shifted in favour of a Bank of England rate cut at the upcoming policy meeting on Thursday. This has been our longstanding view, and our UK economist discusses here why the sticky services CPI may not be a hindrance to easing. It is a close call, but expectation is a 6-3 vote split in favour of a 25bp rate cut.
Markets have remained more hawkish than consensus, having kept the pricing for the August meeting within 14bp for the past month, and are currently expecting 13bp. We think there is some mispricing also on the year-end tenor, which currently sees 52bp of cuts against our call for 75bp. If the BoE does cut this week, then expectations may shift for two extra moves (three in total) in the Sonia curve, potentially dealing a substantial hit on the Pound.
There had already been reasons for a contraction in GBP/USD and a rally in EUR/GBP based on inconsistencies with rate differentials. We think that some USD weakness can limit Cable’s downside, and favour EUR/GBP to display weakness in the Pound this week. We still believe that a move to 0.850+ would be entirely warranted in the near term.
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Growth and inflation data in focus
General consensus is EUR/USD can trade on the strong side this week on the back of the US events discussed above. One-month historical volatility on the pair is now back at the 2024 lows, as the Euro has been broadly unresponsive to both soft domestic surveys and the equity and carry trade-driven positioning adjustments in FX. However, if something can shake EUR/USD from this mid-summer low-volatility torpor, that should be the Fed and/or US data.
Some tier-one figures in the Eurozone are also due this week. The second quarter GDP report tomorrow is expected to show still-tepid 0.5% year-on-year growth, but it will be the flash CPI estimate on Wednesday that should have a greater market impact. The latest European Central Bank meeting has put greater emphasis on data dependence as President Christine Lagarde ditched forward guidance. The expected slowdown from 2.9% to 2.8% in July’s core CPI should not be enough to lead markets to price in more than the 55bp of 2024 easing already in the EUR OIS curve. Incidentally, core inflation has beaten consensus in five of the seven flash estimates since the start of the year.
In the rest of Europe, eyes will continue to monitor closely NOK and SEK, which recently faced a huge sell-off that looks overdone to us by a number of metrics. Expectation is to continue downward corrections in EUR/NOK and EUR/SEK, with the Norwegian currency probably having more room to recover given a stronger rate profile and fundamentals. In Sweden, second quarter GDP surprised on the downside this morning, falling 0.8% quarter-on-quarter and probably keeping pressure on the Riksbank to cut rates despite a weak Krona.
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Downside risks this week
In the US, the two main events of the week are the FOMC rate announcement on Wednesday and the July jobs report on Friday. There is a discussion as to why there are some downside risks for the dollar this week. The June dot plot projections look unreasonably hawkish given the recent data flow and market pricing, and we expect the Fed to pivot towards a more dovish stance in line with recent commentary and in anticipation of a potential September cut.
It must be remembered that the FOMC has a dual mandate and even if there is no conclusive evidence of disinflation yet, unemployment at 4.1% is already above the Fed’s year-end projections, and it's believed policymakers want to avoid unnecessary stress on the economy.
Indeed, markets are already pricing in easing quite aggressively in the US. A September cut is fully factored in and 68bp in total is expected by year-end. The general view is to see the markets adding easing bets across the curve following a dovish hold – perhaps fully pricing in three cuts by year-end – but there is a chance that Fed Chair Jerome Powell errs on the side of caution and delivers a less dovish (and USD-positive) communication package this week.
Anyway, when adding the downside risks from jobs figures on Friday and a potential surprise hike by the BoJ, there is a bearish bias on DXY this week, and a move below 104.0 wouldn't be a surprise.
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