Rising Interest Rates Dampen Risk Appetite


RISING INTEREST RATES WEIGH ON RISK ASSETS

Risk assets came under fresh pressure over the past week, while shorter-dated government bond yields increased in response to speculation of more aggressive monetary policy tightening by the world’s major central banks. US annual consumer price inflation increased to a fresh forty-year high of 9.1%, a stronger outturn than predicted. That boosted speculation that the US Federal Reserve could follow the Bank of Canada’s example (chart 1) by lifting rates by a full percentage point despite signs of moderating economic activity. The Fed will provide a policy update on 27 July. The European Central Bank in the coming week will likely announce its first increase in interest rates since 2011. The US dollar remained broadly supported, as the pound fell briefly below $1.18 and the euro touched below parity for the first time in two decades.


UK MONTHLY GDP LIKELY VOLATILE AROUND JUBILEE

In the UK, monthly GDP for May provided an upside surprise for markets, but the 0.5%m/m increase was in line with our forecast. As we discuss here, June GDP due next month will probably fall quite significantly because of the loss of working days during the Queen’s Platinum Jubilee celebrations. That could lead to a negative outturn for Q2 GDP growth. There will be a rebound in Q3, but the underlying trend is moderating growth. Nevertheless, the Bank of England’s primary focus will be on returning inflation to the 2% target. There will also be ongoing attention on the Conservative leadership contest, with the party’s MPs set to whittle down candidates to the final two by the coming Thursday. Televised debates are scheduled to take place before Monday’s next round of voting. Market reaction to the contest has been limited so far, but there could be additional volatility for sterling assets ahead as markets assess fiscal pledges and prospects for the UK’s future relationship with the EU.


UK DATA SPREE AHEAD OF KEY BOE MEETING

There are several important UK data releases in the coming week for the Bank of England MPC to consider ahead of its next policy update on 4 August. They include the labour market report (Tue), CPI inflation (Wed), GfK consumer confidence (Fri), retail sales (Fri) and the flash PMIs (Fri). Policymakers are expected to decide between whether to step up the pace of tightening with a 50bp increase in Bank Rate to 1.75% or stick with a 25bp increase. Although financial markets have fully priced in a half-point rise, the outcome will probably be more finely balanced. Governor Bailey recently said that there are “more options on the table than another 25 basis points”. He will deliver his annual Mansion House speech (Tue). New Chancellor Zahawi will also address that event. Despite the slight rise in the unemployment rate in last month’s release, the UK labour market remains tight with the focus on high inactivity rates among the working-age population and unfilled vacancies at a new peak. For the three months to May, we expect the unemployment rate to stay at 3.8% and underlying annual pay growth (excluding bonuses) to edge up to 4.3% from 4.2%. We predict annual headline CPI inflation to increase for a ninth straight month, to 9.3% in June from 9.1%, lifted by higher fuel prices. The core measure (excluding food and energy), however, is expected to fall for a second month, to 5.7% from 5.9%, but it will still be at an elevated level. The Queen’s Platinum Jubilee celebrations may have provided a temporary boost to retail sales in June, but high inflation is weighing on the volume of sales over the past year (chart 2). We expect manufacturing PMI to edge up to 53.2 from 52.8, helping by a backlog of orders, but lower non-essential spending is expected to result in services PMI moving down to 53.5 from 54.3.


ECB RATE LIFT-OFF AND ANTI-FRAGMENTATION FOCUS

The ECB (Thu) is expected to raise interest rates for the first time since 2011. The announcement is due at 1.15pm and the press conference at 1.45pm. Conditions for interest rate lift-off have been met and the ECB has signalled its intention to raise rates by 25bp, taking the deposit rate from -0.5% to -0.25%. Similar rises are expected for the main refinancing rate to 0.25% and the marginal lending rate to 0.5%. A further increase in interest rates is expected in the subsequent policy meeting in September, including the possibility of a larger 50bp rise ‘if the mediumterm inflation outlook persists or deteriorates’. With prospects of interest rate rises leading to a widening of euro peripheral bond spreads, markets will also be looking out for details on the ECB’s new anti-fragmentation policy tool including its size and how it would be deployed. Reports suggest that discussions on the new instrument are ongoing, so it is unclear how much detail will be revealed at this stage. Eurostat is expected to confirm Eurozone annual headline CPI inflation (Tue) at 8.6% in June. The earlier flash estimate was stronger than expected. We also expect Eurozone June flash PMIs (Fri) for both manufacturing and services to fall to 51.6 and 52.0, respectively, consistent with further moderation in growth. Eurozone consumer confidence (Wed) is forecast to decline to a record low of -25. There will also be attention on EU contingency plans in case the current annual maintenance period for the Nord Stream pipeline, and therefore disruption to gas supplies from Russia, is extended.


FED BLACKOUT STARTS AND BOJ TO STAND PAT

It is a quieter US economic calendar in the week ahead. There are no Fed speakers as the central bank enters its blackout period ahead of the next policy update. The main data releases relate to housing activity, including housing starts and permits (Tue), as well as the Philadelphia Fed (Thu) and flash PMI surveys (Fri). In contrast to other major central banks, the Bank of Japan (Thu) is expected to keep policy unchanged.


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None of the information in this article is, nor should be construed as financial advice. All foreign exchange transactions involve risk and you should always seek your own independent financial advice before entering into any foreign exchange transaction.

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