monetary policy divergence

10Y US Treasury yields are more than 60bp away from the peak they reached in early March, prior to the regional banking crisis. The Fed has been pushing a more hawkish line disappointed by the lack of progress on the inflation front, but end-2023 Sofr futures still price a rate that is 50bp below the early March peak.   At least so far, this doesn’t feel like a wholesale reappraisal of the market’s macro view although a more forceful Fed communication at the 14 June meeting, with potentially a hike and a higher end-2023 median dot, could push us closer to this year’s peak in rates.     ECB pricing is hard to move but markets look to the BoE for guidance In Europe, today’s inflation prints from France, Germany, and Italy will, in addition to yesterday’s Spanish release, give us a pretty good idea of where the eurozone-wide number will fall tomorrow. If the drop in Spain’s core inflation is any guide, EUR markets will struggle to follow their US peers higher.   Add to this that it is difficult for euro rates to price a path for policy rates that materially diverges from their US peers. Even if the Fed hikes in June or July, the EUR swap curve already prices ECB hikes at both meetings. Swaps assign a low probability to another hike in September for now.   That probability may well rise but we think any labour-market induced sell-off in US Treasuries will reflect, in part, in wider rates differentials between the two currencies.   It is difficult for euro rates to price a path for policy rates that materially diverges from their US peers  

Norges Bank turns hawkish in fight against weaker krone Norges Bank has not only hiked rates faster than expected this month, but is also signalling plenty more tightening to come. We suspect the newly forecasted peak rate of 4.25% will be hit by the end of the third quarter. This puts NOK in a stronger position, especially against its closest peer SEK.   Norway’s central bank has hiked rates by 50 basis points, more than the 25bp that was expected – although in truth the consensus was pretty divided. What really stands out is the new interest rate projection, which is the output of Norges Bank’s model and shows where policymakers expect rates to go over the coming months. Back in March, that pointed to a peak rate of 3.5%, which implied the bank would have hiked by 25bp this month before pausing. Not only has the central bank gone further than that at this meeting, but it is now signalling a peak rate of 4.25% later this year – some 60bp higher than previously anticipated. By historical standards, that's a pretty big revision. To some extent that’s not surprising, given that the last set of forecasts came amid the US banking crisis. Global interest rate expectations have since recovered, which mechanically pushes up Norges Bank’s forecast for its own policy rate. NOK was as much as 5.5% weaker at the end of May on a trade-weighted basis, relative to what the central bank had been assuming back in March, though that difference has narrowed over recent days. That weakness also requires higher rates, according to the bank's model.   Norges Bank has increased its interest rate projection – again   But the central bank also says that higher-than-expected inflation and wage growth will also force it to do more – and interestingly it’s this which accounts for most of the upward revision to interest rate projections this year, according to a chart in the Monetary Policy Report. The bottom line is that the central bank expects another 50bp of rate hikes from here, and whether we get that in one burst or two 25bp increments probably depends on whether the krone depreciates further from here. It’s worth noting that the new forecasts assume a gradual appreciation over the coming quarters. Either way, we suspect the newly-forecasted terminal rate of 4.25% will probably have been reached by the end of the third quarter. Further hikes over and above that can't be ruled out.     One more reason for NOK outperformance over SEK The blowout hawkish surprise by Norges Bank today – both in the magnitude of the hike and the rate projection revisions – puts NOK in a relatively strong position against other high-beta peers. That is because monetary policy divergence has become an increasingly more relevant driver for FX, and if indeed we see the Federal Reserve cycle coming to an end and FX volatility decline, the search for carry will reward currencies with more attractive implied rates.   Looking at EUR/NOK, it is still too early to call for a sustained downward trend, despite Norges Bank’s ultra-hawkish turn. That is because the ECB is keeping the euro idiosyncratically strong, NOK is still the least liquid G10 currency (so the most exposed to corrections in risk sentiment) and because Norges Bank has been less NOK-supportive on the FX purchase side (July announcement next week) than it has been on the monetary policy front.   We see NOK outperform SEK for now, considering the Riksbank should struggle to deliver a similar hawkish surprise given domestic economic woes. We might see a jump to 1.03 and even 1.04 in NOK/SEK in the near term, should the Riksbank fail to offer a floor to SEK. EUR/NOK remains, in our view, vulnerable to some upward corrections in the coming weeks, but if Norges Bank delivers on its plans to take rates to 4.25% (i.e. above our estimated ECB peak rate), then EUR/NOK can trade below 11.00 before the end of this year.

The Federal Reserve has clearly won the fight against inflation. Victory is not inevitable, and its timing is not determined, but no one is talking about stagflation or hyperinflation at the moment. The markets responded favorably to the June consumer price index, fueling the dollar sell-off.   EUR/USD surged to 15-month highs, and this is far from the limit. Economists at Deutsche Bank expect EUR/USD to rise to 1.15 by Q4 2023, while Eurizon SLJ Capital suggests the 1.2 level. When the divergence in monetary policy between the European Central Bank and the Federal Reserve is accompanied by heightened global risk appetite and the decline of American exceptionalism, the US dollar is forced to raise the white flag. Currently, the gap between consumer and producer prices is at a record high. When such situations have occurred in the past, stock markets have risen. This has happened either in the very late stages of a recession or in the early stages of an upturn.        The Federal Reserve has clearly won the fight against inflation. Victory is not inevitable, and its timing is not determined, but no one is talking about stagflation or hyperinflation at the moment. The markets responded favorably to the June consumer price index, fueling the dollar sell-off. EUR/USD surged to 15-month highs, and this is far from the limit.   Economists at Deutsche Bank expect EUR/USD to rise to 1.15 by Q4 2023, while Eurizon SLJ Capital suggests the 1.2 level. When the divergence in monetary policy between the European Central Bank and the Federal Reserve is accompanied by heightened global risk appetite and the decline of American exceptionalism, the US dollar is forced to raise the white flag. Currently, the gap between consumer and producer prices is at a record high. When such situations have occurred in the past, stock markets have risen.   This has happened either in the very late stages of a recession or in the early stages of an upturn.      

GBP: Retail sales disappoint The UK released retail sales data for July this morning, and the numbers came in quite markedly below expectations. Retail sales including fuel dropped 1.2% month-on-month, and the ex-auto fuel gauge was down 1.4%. The release is in contradiction with a slew of quite supportive data releases for the pound. However, the FX impact has been quite contained given the very little weight that retail sales are given in the Bank of England’s monetary policy decision equation compared to wage and inflation figures, which instead surprised on the upside this week. The Sonia curve is fully pricing in a 6.0% peak rate in the UK, while markets are not convinced the ECB will hike rates at all. Incidentally, the euro is more exposed to China than the UK. That would suggest the 0.8500 support in EUR/GBP is under threat, and we definitely don’t exclude it will be tested or broken temporarily in the coming days. However, the short-term swap differential when the pair last traded at 0.8500 (mid-July) was around 20-25bp wider in favour of GBP, meaning that a further widening of the monetary policy divergence may well be needed to keep EUR/GBP sustainably depressed.

Stubborn resilience in US activity data and risk-off waves from China have translated into a strengthening of the dollar over the summer. We still think this won’t last much longer and see Fed cuts from early 2024 paving the way for EUR:USD real rate convergence. Admittedly, downside risks to our EUR/USD bullish view have grown.   Still awaiting the turn in US activity data The underlying factors driving FX markets became "crystallised" over the summer, as investors waited in vain for a negative turn in US economic activity that would justify a dovish shift in both the Federal Reserve's rhetoric and market pricing. However, since forward-looking indicators and evidence from the job market have not shown enough reason to cast doubt on the resilience of the US economy, US yields have faced limited resistance once again. This has made it increasingly discouraging, particularly in real terms, to play the long bearish game through dollar shorts. At present, the US dollar index finds itself at a critical juncture, trading close to 104 (a multi-month high), and is about to face a month where decisions made by the central banks of both the US and the eurozone will determine whether it can break through to the March peaks (105.60) and beyond. Our economists expect no further interest rate hikes by the Federal Reserve, and while it is a close call, we anticipate the European Central Bank to deliver one final 25bp raise in September. In other words, we have reason to believe that the dollar may have reached its peak around current levels. Another reason for the dollar's resilience has been the influx of negative news from China. The dollar typically benefits from a deterioration in Chinese sentiment through two channels: directly through yuan depreciation (to which USD is highly correlated) and indirectly through the risk environment channel. It is conceivable that there could be a further deterioration in investor sentiment regarding China in the coming months. However, the People's Bank of China's determined defence of the renminbi means that the dollar may only gain indirectly from these developments. Looking beyond the near term, monetary policy divergence is expected to remain the overwhelmingly predominant factor driving currency trends into the next year. Another way to consider this is through short-term real rates. For example, EUR/USD has closely followed its short-term real rate spread since 2020. If nominal rate fluctuations have been the primary force behind these real rate changes thus far, the end of tightening cycles may result in a period where the inflation rates, on the right side of the subtraction, gain more significance.   Our EUR:USD real rate forecast    

Remember that 'back to school' feeling at the end of summer? A tedious car journey home after holiday fun, knowing you'll be picking up where you left off? I'm afraid we've got a very similar feeling about the global economy right now. 'Are we nearly there yet?'. No. Very few reasons to be cheerful Lana del Rey's Summertime Sadness classic comes to mind as we gear up for autumn. And I'm not just talking about chaotic weather or even, in my case, disappointing macro data. Most of us have had the chance to recharge and rethink over the past couple of months. and I'm afraid all that R&R has done little to brighten our mood as to where the world's economy is right now. Sure, the US economy has been holding up better than we thought. And yes, the eurozone economy grew again in the second quarter. Gradually retreating headline inflation should at least lower the burden on disposable incomes. And let's be thankful for the build-up of national gas reserves in Europe, which should allow us to avoid an energy supply crisis this winter unless things turn truly arctic. But that's about as upbeat as I can get. We still predict very subdued growth to recessions in many economies for the second half of the year and the start of 2024. The stuttering of the Chinese economy seems to be more than only a temporary blip; it seems to be transitioning towards a weaker growth path as the real estate sector, high debt and the ‘de-risking’ strategy of the EU and the US all continue to weigh on the country's growth outlook. In the US, the big question is whether the economy is resilient enough to absorb yet another potential risk factor. After spring's banking turmoil, the debt ceiling excitement, and more generally, the impact of higher Fed rates, the next big thing is the resumption of student loan repayments, starting in September. Together with the delayed impact of all the other drag factors, these repayments should finally push the US economy into recession at the start of next year. And then there's Europe. Despite the weather turmoil, the summer holiday season seems to have been the last hurrah for services and domestic demand in the eurozone. Judging from the latest disappointing confidence indicators, the bloc's economy looks set to fall back into anaemic growth once again   Little late summer warmth This downbeat growth story does have an upbeat consequence; inflationary pressure should ease further. It's probably not going to be enough to bring inflation rates back to central banks’ targets, but they should be low enough to see the peak in policy rate hikes. Central bankers would be crazy to call an end to those hikes officially; they don't want to add to speculation about when the first cuts might come, thereby pushing the yield further into inversion. And there's also the credibility issue - you never know, prices might start to accelerate again. So, expect major central bankers to remain hawkish at least until the end of the year. In our base case, we have no further rate hikes from the US Federal Reserve and one final rate rise by the European Central Bank.   However, in both cases, these are very close calls, and the next central bank meetings are truly data-dependent. Sometimes, a Golden Fall or Indian Summer can make up for any summertime sadness. But it doesn’t look as if the global economy will be basking in any sort of warmth in the coming weeks. The bells are indeed ringing loud and clear. Vacation's over; school is here. And while I'm certainly too old for such lessons, I'm taken back to that gloomy, somewhat anxious feeling I had as a kid as summer wanes and the hard work must begin once again.   Our key calls this month: • United States: The US confounded 2023 recession expectations, but with loan delinquencies on the rise, savings being exhausted, credit access curtailed and student loan repayments restarting, financial stress will increase. We continue to forecast the Federal Reserve will not carry through with the final threatened interest rate rise. • Eurozone: The third quarter may still be saved by tourism in the eurozone, but the latest data points to a more pronounced slowdown in the coming months. Inflation is falling, but a last interest rate hike in September is not yet off the table. The European Central Bank will be hesitant to loosen significantly in 2024. • China: The latest activity data has worsened across nearly every component. Markets have given up looking for fiscal stimulus, and have started making comparisons with 1990s Japan. We don’t agree with the Japanification hypothesis, but clearly a substantial adjustment is underway, and we have trimmed our growth forecasts accordingly. • United Kingdom: Uncomfortably high inflation and wage growth should seal the deal on a September rate hike from the Bank of England. But emerging economic weakness suggests the top of the tightening cycle is near, and our base case is a pause in November. • Central and Eastern Europe (CEE): Economic activity in the first half of the year has been disappointing, leading us to expect a gloomier full-year outlook. Despite this, we see a divergence in economic policy responses, driven by countryspecific challenges. • Commodities: Oil prices have strengthened over the summer as fundamentals tighten, whilst natural gas prices have been volatile, with potential strike action in Australia leading to LNG supply uncertainty. Chinese concerns are weighing on metals, but grain markets appear more relaxed despite the collapse of the Black Sea deal. • Market rates: The path of least resistance is for longer tenor rates to remain under upward pressure in the US and the eurozone and for curves to remain under disinversion (steepening) pressure. We remain bearish on bonds and anticipate further upward pressure on market rates from a tactical view. • FX: Stubborn resilience in US activity data and risk-off waves from China have translated into a strengthening of the dollar over the summer. We still think this won’t last much longer and see Fed cuts from early 2024 paving the way for EUR:USD real rate convergence. Admittedly, downside risks to our EUR/USD bullish view have grown.     Inflation has only been falling for a matter of months across major economies, but the debate surrounding a possible “second wave” is well underway. Social media is littered with charts like the ones below, overlaying the recent inflation wave against the experience of the 1970s. These charts are largely nonsense; the past is not a perfect gauge for the future, especially given the second 1970s wave can be traced back to another huge oil crisis. But central bankers have made no secret that nightmares of that period are shaping today's policy decisions. Policymakers are telling us they plan to keep rates at these elevated levels for quite some time.