Dollar and Sterling Soft Ahead of BOE

united kingdom

  • The dollar is trading softer today, seemingly in response to developments at the Fed 
  • The Bank of England is widely expected to raise interest rates 
  • The US tax reform is expected to be unveiled today  
  • Czech National Bank is expected to hike rates 25 bp to 0.5% 

The dollar is broadly lower against the majors in the wake of Fed developments. The Antipodeans are outperforming, while the yen and sterling are underperforming. EM currencies are mostly firmer. ZAR and PHP are outperforming, while CNY and INR are underperforming. MSCI Asia Pacific was up 0.2%, with the Nikkei rising 0.5%. MSCI EM is flat, with the Shanghai Composite falling 0.4%. Euro Stoxx 600 is down 0.1% near midday, while S&P futures are pointing to a lower open. The 10-year US yield is flat at 2.38%. Commodity prices are mixed, with WTI oil up 0.3%, copper down 0.7%, and gold up 0.1%.

The dollar is trading softer today, seemingly in response to developments at the Federal Reserve. Yet neither the FOMC decision nor the press reports suggesting that Governor Powell will be nominated (and easily approved) as Fed Chair came as a surprise. The Fed upgraded its economic assessment. The December Fed funds futures contract closed unchanged for the eighth consecutive session on Wednesday, implying an average effective Fed funds rate of 1.275%. We estimate that if a 25 bp hike were fully discounted, fair value is 1.295%.

There has been much speculation over the past several months who Trump will pick as the next Fed Chair. While many acknowledge the fine job Yellen has done in steering the Fed through the tapering, initial rate increases, and now the balance sheet reduction, there is a sense that political considerations simply do not favor her reappointment. Indications from Washington have persuaded most observers that Powell will likely get the nod, but the surprise may be that Taylor could still in be in the running to replace Fischer as Vice Chairman.

The Bank of England is widely expected to raise interest rates. A rate hike would put to rest the knock on Governor Carney of not delivering on a single rate hike despite his numerous threats. The reason that the BOE would raise rates is that inflation is projected to be above target for some time and the economy, while slowing, is near full-employment. There does not appear to be much spare capacity.

On the other hand, the reason why some would dissent for a rate hike (by perhaps one or both Deputy Governors) is that inflation is largely an echo from the past depreciation of sterling. It will soon drop out of the year-over-year measures. If the economy is already slowing, and household discretionary spending is being squeezed by inflation and miserly wage increase, a pro-cyclical monetary policy does not seem the best way to extend the expansion. Remember too, higher rates pass through to the households relatively quickly due to the widespread practice of floating rate mortgages.

A compromise may be a dovish hike, where Governor Carney makes clear his reservations and signals that this is not the beginning of a tightening cycle. He may emphasize the risks also speak to a cautious approach. Still, being able to engineer a dovish hike partly depends on luck and existing conditions. The best way to ensure a drop in sterling is not to hike rates, though a signal that a hike may still be delivered next month would likely limit the losses after the knee-jerk surprise.

Ahead of the BOE, the UK reported October service PMI. It was 50.8 vs. 48.5 expected, and comes after a stronger than expected manufacturing PMI yesterday.

The US tax reform is expected to be unveiled today. We remain struck by how fluid the issues seemed to up until the last moment. Even the one-day delay, while not material, makes for poor optics. The market will have a knee-jerk reaction to the headlines as markers are placed on expected winners and losers. Sharp moves are unwarranted, as it is very early on in the process. Health care reform also passed committee. The immediate reaction to initial proposals may create opportunities for investors looking for particular assets (either to buy or to sell).

Eurozone final October manufacturing PMI readings were reported. The headline reading was revised down a tick to 58.5. Looking at the country readings, Spain was 55.8 vs. 54.8 expected, Italy was 57.8 vs. 56.5 expected, France was 56.1 vs. 56.7 expected, and Germany was 60.6 vs. 60.5 expected. Germany also reported October employment data. Unemployment fell -11k vs. -10k expected, while the unemployment claims was steady at 5.6%.

Australia reported September trade data. A surplus of AUD1.75 bln was reported vs. AUD1.2 bln expected. September building approvals also surprised on the upside, rising 1.5% m/m vs. -1.0% expected. Still, the RBA is widely expected to remain on hold well into next year as the inflation outlook remains benign.

Czech National Bank is expected to hike rates 25 bp to 0.5%. It has been on hold since the initial 20 bp hike to 0.25% back in August. Since that move, EUR/CZK has fallen about 2%. The central bank’s models suggest a 1% appreciation of the koruna is equivalent to a 25 bp hike. However, given the robustness of the economy, a 25 bp hike today is still warranted.