Divergence Will Grow Between Bank of England & Fed
A growing separation is brewing between the pace of policy tightening at the two most hawkish G10 central banks. As the risks from Greece and China were quickly subdued over the past week, markets have refocused on the timeline for tightening from the Federal Reserve and the Bank of England. This week Janet Yellen was notably more upbeat on the economy in her biannual congressional testimony. She noted that a rate hike would represent a “healing” from the financial crisis, and that the economy could “snap back” from first quarter weakness. In Mark Carney’s headlines this week he also spoke about moving towards a rate hike, using what is becoming an often used platitude: “The point at which interest rates may begin to rise is moving closer”.
Both currencies have taken a bad data point in stride this week as US core retail sales and UK employment numbers missed estimates. June US core retail sales were reported at -0.1% vs 0.7% estimated, with a downward revision to 0.8% from 1.0% on the May number. Given the big declines in oil recently, it is important to also account for the impact of falling gas prices. Excluding autos, gas and building materials retail sales fell by 0.1% vs estimates of 0.3%. Declines in sales were broad, but it is clear that energy prices are having a big impact. The US dollar took this report in stride. The initial dip was bought and the Dollar continued to gain later in the week as inflation and building permit data beat expectations.
Data from the United Kingdom showed a miss in CPI as well as the first rise in unemployment claimants in two years. Much attention was focused on the unemployment data that were released the day after Carney’s comments boosted Sterling broadly. Given the disappointment of UK numbers, it is becoming clear that the hike from the FOMC will come much sooner than the MPC’s. As this separation grows Sterling may suffer versus the Dollar as Janet Yellen jumps out to a firm lead in the rate hike race.
Post retail sales, September only shows a 12% chance of hike, with October at 26% and December at 48%. These percentages are based off the Eurodollar futures market which seems to under appreciate Yellen’s words this week about moving sooner so that the path of hikes may be more gradual. Short sterling futures predict a Bank of England hike around May/June 2016. The danger going forward is that the Federal Reserve hikes sooner than futures markets currently predict. It is strange that fixed income instruments continue to discount the FOMC’s resolve, even as many economists have circled September as a possible liftoff meeting. By the time the Bank of England gets around to its first hike the Fed may be approaching its second or third move. This divergence should become more apparent in the next few weeks as the impact of the Greek debt crisis spreads across Europe.
One trend I have noticed in the last year is that as rate hike expectations ebb and flow, different currencies come into the line of fire vs the US Dollar depending on the outlook for that particular central bank. First the 0% yielding currencies are hit, which is why EUR and JPY have crowded short positions. This initial jump in the Dollar in tandem with the Chinese slowdown hurt commodity prices broadly, which then weighed down AUD, NZD and CAD. Now that we are coming into the closing stretch, the next currency to be hit will be Sterling. Mark Carney already has a reputation for flip flopping on hiking rates, so watch out for Sterling sliding against the Dollar as markets finally realize Carney will drag his feet relative to the FOMC.