FX Weekly

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FX consolidation ahead of key inflation data

FX View:

The plunge of the US dollar last week as US yields fell after the FOMC meeting and US jobs data has not been extended this week and the reversal of US dollar weakness has resulted in US dollar strength across nearly all G10 currencies. The consolidation this week in part reflects the lack of data to influence monetary policy expectations. That will change next week with the release of US and UK CPI data for October. We focus on the potential impact from the data from the UK next week and conclude that there is scope for the UK rates market to adjust further lower given the prospect of continued weak economic data, which was highlighted today with the GDP data and will likely be followed next week by a sharp drop in CPI and further signs of weakness in the labour market. GBP risks remains to the downside as the rates market adjusts further to highlight more BoE rate cuts.

USD REBOUNDS ACROSS NEARLY ALL G10 CURRENCIES THIS WEEK

Source: Bloomberg, 14:15 GMT, 10^th November 2023 (Weekly % Change vs. USD)

Trade Ideas:

We have closed our short USD/MXN trade idea after our stop-loss level was hit but have maintained our short USD/SEK trade idea.

JPY Flows:

The monthly Transactions in International Securities data for October was released this week and we analyse the data which showed further buying of foreign bonds by Japan investors – the year-to-date total is now a record JPY 19.4trn, nearly offsetting the sales of JPY 20.1trn in the same period in 2022.

Short Term Fair Value Modelling:

This week we monitor the relationship between spot and fair value for our JPY, GBP and EUR short-term regression models. We identify a growing convergence in the relationship between EUR/USD and the calculated fair value where our EUR/USD model calculates a -1.6% undervaluation of spot up from recent lows of -4.0% seen in early October. GBP/USD has seen a similar convergence where GBP remains under-valued at 3.5% up from recent lows of 6.0%. USD/JPY is currently overvalued at 2.9%

FX Views

GBP: How long does the BoE plan to keep rates on hold for “extended” period?    

After correcting lower throughout most of September, the GBP has since been consolidating at lower levels over the past month. Cable attempted to break higher after the release of the much weaker nonfarm payrolls last Friday but failed to break above resistance from the 200-day moving average at around 1.2435. On the other hand EUR/GBP has been attempting to break higher but is currently struggling to extend its advance beyond 0.8700-0.8750 after climbing above resistance from the 200-day moving average at around 0.8690 on 19^th October.                             

The performance of the GBP so far this year has been tightly linked to short-term yield differentials. In the first half of this year, the GBP outperformed. It was the best performing G10 currency when it strengthened by 5.1% against the USD and by 3.2% against the EUR. The sharp strengthening of the GBP was mainly driven by the hawkish repricing of BoE rate hike expectations between March and June. The UK rate market over that period moved to price in a peak policy rate for the BoE of close to 6.50% which was expected to be the highest amongst major and other G10 central banks. Then in early July BoE rate hike expectations peaked out, and market participants have since continued to scale back expectations. The BoE’s latest policy update (click here) at the start of this month has reinforced expectations that the 0.25 point hike delivered in September was the last in the current tightening cycle. While the BoE did not rule out further hikes, the updated forward guidance placed more emphasis on maintaining restrictive rates for an “extended period of time”.        

With the BoE now indicating more strongly that their rate hike cycle has peaked, market attention has naturally started to shift to when the BoE could begin to reverse policy tightening. It has already prompted BoE policymakers to actively discourage market participants from prematurely pricing in rate cuts. The BoE is now planning to leave rates on hold but it is less clear in outlining for how long. BoE Chief Economist Huw Pill gave the clearest indication so far that “for an extended period of time” could be consistent with the BoE leaving rates on hold though the 1H of this year and then beginning to cuts rates from the 2H of next year. He stated that current market pricing for the BoE to consider lowering rates from the middle of next year “doesn’t seem totally unreasonable, at least for me”. The UK rate market is currently pricing in around  16bps of BoE rate cuts by the June MPC meeting and 25bps by the August MPC meeting.

GBP PERFORMANCE VS. SHORT-TERM YIELD SPREADS

Source: Bloomberg, Macrobond & MUFG GMR

UK ECONOMY IS RUNNING CLOSE TO STALL SPEED

Source: Bloomberg, Macrobond & MUFG GMR

The recent loss of cyclical momentum for the UK economy and slowing inflation is helping to ease pressure on the BoE to raise rates further into restrictive territory. In their latest Quarterly Inflation Report (QIR) the BoE revised down their forecasts for GDP with the UK economy expected to stagnate through to the end of next year. The UK GDP report for Q3 revealed flat growth that was consistent with the BoE’s more downbeat economic outlook. The details of the report were even weaker as positive contributions from net trade and inventories offset weak domestic demand. Private consumption fell by -0.4%Q/Q and business capex by -4.2%Q/Q. The service sector contracted by -0.1%Q/Q in Q3 following flat growth in Q2. The BoE is expecting only a marginal pick-up in growth in Q4 (+0.1%Q/Q).

The release next week of the latest UK CPI report for October is expected to provide further evidence that inflation is slowing more sharply. The BoE expects the headline rate of inflation to fall to just under 5.0% in October mainly driven by lower energy prices. The OFGEM price cap increase of 80% in October 2022 will drop out of the CPI annual calculation of utility prices, resulting in a sharp drop. At the same time, food price inflation is expected to ease further from 12.1% in September to around 9% in Q4. As Chief Economic Huw Pill noted the sharper fall in headline inflation will help to make the UK appear less of an outlier compared to relatively lower rates of inflation in the euro-zone (CPI @ 2.9% in October) and US (CPI expected at 3.3% in October). However, the BoE has indicated that it will be mainly focusing on developments in core and services inflation where it is less clear so far that upward pressures have eased and remain elevated. Services inflation has slowed over the last two months but is not yet sufficient evidence to give the BoE confidence that it will be sustained. After slowing between May and August, core inflation picked up in September.

The BoE’s latest QIR highlighted that they remain concerned over persistent inflation risks when they also downgraded their growth forecast for the supply side of the economy. The medium-term equilibrium unemployment rate is judged to be temporarily higher at around 4.5%. It compares to the current unemployment rate of 4.0% and implies that the labour market will need to weaken even more to give the BoE confidence that inflation will return to target on a sustained basis. The BoE’s updated projections were revised higher to show the unemployment rate rising to 4.25% by the end of this year, 4.75% by the end of next year and 5.0% by the end of next year.

In these circumstances, we continue to expect the GBP to weaken further as the UK rate market moves to price in more BoE cuts into next year (currently around 60bps of cuts priced by December 2024). However it will require more evidence of slowing UK inflation and a softening labour market to drive it lower in the week ahead. 

HAS THE BOE OVERTIGHTENED POLICY?  

Source: Bloomberg, Macrobond & MUFG GMR

HOW QUICKLY IS INFLATION SLOWING IN THE UK?

Source: Bloomberg, Macrobond & MUFG GMR

Weekly Calendar

Source: Bloomberg, Macrobond & MUFG GMR

Key Events:

• The latest UK labour market and CPI reports will be scrutinized closely in the week ahead, and could trigger a reassessment of current market expectations that the BoE is unlikely to raise rates further. The BoE have been emphasizing that the recent rise in the annual rate of growth of average weekly earnings has not been apparent in other indicators of pay but there was common signal that wage growth remained elevated at around 7%. The BoE has become more pessimistic over the supply side of the labour market which is contributing to ongoing concerns over the risk of persistent inflation. The release of the latest CPI report is expected to reveal that headline inflation fell sharply back below 5.0% in October driven mainly by the drop in the Ofgem price cap. However, the BoE will be mainly focusing on measures of core and services inflation.           

• The release of the latest US CPI and retail sales report for October will attract more attention in the week ahead after the US rate market has moved to price out a final Fed hike in December. Core inflation has slowed since the middle of the year but picked up in recent months. A softer print will be required in October to provide reassurance that the underlying trend continues to slow. The Fed is also watching to see if the US economy slows after unexpectedly robust growth in Q3. The retail sales report for October is expected to provide evidence that consumer spending slowed at the start of Q4 after control retail sales growth averaged 0.6% M/M in Q3.

• The latest monthly activity data (retail sales, industrial production, FAI & property investment) from China for the month of October will indicate whether China’s economy continued to strengthen heading into year-end in response to policy stimulus. The IMF recently raised their growth forecast for this year by 0.4ppt to 5.4% after taking into account the government’s new fiscal stimulus plans.