This week we have key interest rate decisions from both the U.S. Federal Open Market Committee and the [UK's] Bank of England's Monetary Policy Committee.
This article is a brief preview of both events and it's been written for business folks, not markets folks. If you'd like something more technical then here's some suggested reading:
- ING: Four scenarios for the BoE
- FT: Preview of both BoE and Fed
- City Index: Fed Preview
- ING: Fed Preview
- Bloomberg: BoE Preview
Economic Backdrop
Interest rates have been at historically low levels since the 2008 global financial crisis. Lower interest rates stimulate economic activity as borrowing is cheaper, encouraging investment and spending.
In addition to reducing borrowing costs, both the Fed and the BoE (in addition to the ECB and BoJ, among others) also ran another, somewhat more unconventional, expansionary policy called quantitative easing. QE involves the central bank purchasing government bonds and other financial assets to inject cash, increase the money supply, and lubricate the gears of finance.
We can see from the chart below that the Fed started to lift rates in 2016, and the BoE followed suit in 2017, in response to gently rising inflation as both economies recovered from a long slump post the financial crisis.
Then in 2020, the world was shaken by the coronavirus pandemic, which caused economic activity to grind to a halt and central banks to immediately reach for the life support and governments to announce exceptional fiscal policy packages to prevent a crisis of joblessness.
The pandemic caused tremendous disruption to global supply chains, with manufacturing and shipping worker shortages, port closures, and stretched just-in-time supply models. Moreover, with lockdowns consumers were spending nothing or much less on travel, eating and drinking out, and on the high street. Instead, people bought "stuff" that was largely delivered to them at home.
As demand for stuff was increasing and supply chains were collapsing, lockdowns were easing and people had bulging bank accounts full of savings from months of sitting at home and receiving furlough pay in the UK, or fat stimulus cheques in the US. This is probably why there was a massive uptick in retail stock and crypto trading: nothing to do and money burning a hole in the bank account!
This all fuelled inflation – an increase in prices year-over-year – although it was thought for basically all of 2021 that inflation was "transitory," i.e. only temporary and likely to cool off after the pandemic supply issues were resolved. The term transitory was dropped by the end of 2021 as it seemed that inflation would be here to stay for a little while longer, then Russia invaded Ukraine which changed the game completely.
Rates and Inflation
Central banks use monetary policy as a tool to "control" inflation, or rather to react and hope that by changing the behaviour of consumers and businesses, they can nudge demand in order to equalise price increases.
If inflation is rising, then the reaction of central banks is to "tighten" policy by raising interest rates. This will increase borrowing costs and discourage spending. Consumers and businesses will become more cautious, they'll save more, and they'll spend less. The obvious problem to avoid is causing a recession and generating unacceptable levels of unemployment. Tinkering like this can be dangerous, but it's the lesser of two evils (on a macro basis).
Markets Backdrop
The pound has been on a long-term losing streak against the dollar, falling from about $1.42 in July 2021 to below $1.25 in late April 2022.
There was some optimism in late 2021 as the Bank of England elected to raise interest rates by 15 basis points and lift off the record low rate of 0.1% to 0.25%. At the same time, the fears over the Omicron variant of the coronavirus was reducing and safe-haven demand for the dollar dropped. This sent GBPUSD up 5-cents from $1.32 to $1.37!
The BoE went on to hike another two times by the more customary 25 basis points, taking the Bank Rate up to 0.75%. Although during this time, the rhetoric from the BoE changed from quick aggressive, or "hawkish", to a more concerned, "dovish" tone. This was sparked by Russia's invasion of Ukraine and more gloomy predictions for future growth from the UK given the burgeoning cost-of-living crisis.
Russia's invasion of Ukraine triggered a global flight into the US dollar, a perennial "safe-haven currency." Meanwhile, the Fed became more aggressive in its messaging, and there's talk of several rate hikes this year, with an expected policy rate around the 3% level by the year's end.
The outlook for the UK economy took a sharp shot across the bow in late April as very poor retail sales data showed a more hesitant consumer. This was the catalyst for a five-day losing streak for the pound, taking the GBPUSD rate to levels not seen since July 2020.
What to Expect
- The Fed is fully priced-in to raise rates by 50 basis points, from 0.5% to 1%, although there is probably going to be some talk of a larger hike from one or two Fed members
- The BoE is highly likely to raise rates by 25 basis points, from 0.75% to 1%
In terms of a market reaction, frankly betting on binary events such as an interest rate decision, is a fool's errand. Markets can react in unexpected ways and often it's the language in the accompanying meeting report or used in subsequent press conferences that can shift prices.
Because markets are geared up for at least a 50bps hike from the Fed and a 25bps hike from the BoE, any diversion from this could prompt a reaction. At Oku Markets we expect the Fed to be aggressive in tone and we wouldn't be surprised to see one or possibly two Fed policy-setters dissent and vote for a 75bps hike. We also expect to see the BoE continue with a cautious tone and to comment on the reduced growth projections for the UK. If there's any modicum of hesitation from the Fed then we could see a relief rally in GBPUSD, otherwise, we'll have to wait and see!
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