Policy divergence is triggering a pick-up in FX volatility

USD: Fed Chair Powell signals a delayed start to rate cut cycle

The US dollar has continued to trade at stronger levels during the Asian trading session after the dollar index hit a fresh year to date high yesterday of 106.52. It has was the sixth consecutive higher closing price for the dollar index during which period it has strengthened sharply by 2.5% from the low on 9th April to yesterday’s high. The dollar index’s gains are even more impressive year to date having increased by almost 6% from the low at the end of last year. The US dollar’s gains were most evident yesterday against emerging market currencies. In particular the Indonesian rupiah, Mexican peso, Brazilian real and Policy zloty all suffered heavy sell-offs as investors cut back on risk. The sharp ongoing rise in US yields is beginning to weigh more heavily on risk assets. MSCI’s global equity index has suffered its sharpest sell-off since October of last year which has brought an abrupt end to the largely uninterrupted rally over the last five when global equities have increased strongly by almost 25%. The key trigger for the current phase of de-risking by global investors has been the reluctant acknowledgement that the Fed is no longer planning to loosen monetary policy as much as previously planned. The back-up in US yields, stronger US dollar and falling equity prices are all contributing to a re-tightening of financial conditions. A delayed start to the Fed’s easing cycle also increases the risk that monetary policy will remain too tight for too long and is undermining confidence in the outlook for a soft landing for the global economy.

The hawkish repricing of Fed rate cut expectations was further encouraged yesterday by comments from Fed Chair Powell. He stated that “the recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence” that inflation will continue to slow back towards their 2.0% target. He added that “we think policy is well positioned to handle the risks that we face. Right now, given the strength of the labour market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work”. The relatively hawkish comments from Fed Chair Powell back up market expectations that the Fed is no longer planning to begin cutting rates in June, and could even signal that the first rate cut is unlikely to be delivered until September rather than July although it will ultimately depending on data releases in the coming months. The probability of a July rate cut has fallen below 50%. With the Fed on course to lag behind the ECB in cutting rates who have signalled that they plan to cut rates in June unless there is a surprise in the coming months, it is opening up a window of monetary policy divergence in the near-term that is supportive for a stronger US dollar.

FX VOLS PICKING UP ALONGSIDE GLOBAL EQUITY MARKET SELL-OFF

Source: Bloomberg, Macrobond & MUFG GMR

GBP: Stronger UK CPI report & wage data helping to support pound

The pound has also strengthened against the euro over the past week although to a lesser extent than the US dollar. It has resulted in EUR/GBP falling from a high of 0.8586 on 5th April to a low today of 0.8527 as the pair moves back closer to support at the 0.8500-level which has held since the middle of last year. The main trigger for the move lower in EUR/GBP this morning has been the release of the latest UK CPI report for March. The report revealed that both headline and core inflation came in stronger than expected at 3.2% and 4.2% respectively in March. The BoE will be concerned as well that service sector inflation remains more elevated at 6.0%. Headline inflation is still on course to fall sharply back towards 2.0% in Q2 driven by another reduction in the Ofgem energy price cap this month.

Together with the stronger than expected wage data released yesterday in the latest UK labour market report, both data releases should make the BoE more cautious over beginning to cut rates until they have more confidence that persistent inflation risks continue to ease. Average weekly earnings growth excluding bonuses is still too strong at 6.0% to provide comfort for the BoE. Recent developments have encouraged UK rate market participants to push back the timing of the first BoE rate cut until the August MPC meeting.

However, an earlier BoE rate cut still can’t be ruled out. BoE Governor Bailey hinted that they might be able to lower rates ahead of the Fed when speaking at the IMF meetings. He noted that there is “more demand-led inflation pressure” in the US than seen in the UK and in Europe. He sees “strong evidence” that UK price pressures are retreating. After the last MPC meeting Governor Bailey signalled that rate cuts are “in play” at forthcoming MPC meetings. The recent deterioration in UK labour market conditions could also play a role in putting more pressure on the BoE to cut begin cutting rates ahead of the Fed. Softening labour demand and a further rise in the unemployment rate could make it more uncomfortable for the BoE to wait much longer before cutting rates. In these circumstances, we expect the pound to weaken further against the US dollar in the near-term although it may eke out further modest gains against the euro.

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
EC	10:00	CPI (YoY)	Mar	2.4%	2.6%	!!!
EC	11:00	EU Leaders Summit	--	--	--	!!
EC	16:45	ECB's Schnabel Speaks	--	--	--	!!
UK	17:00	BoE Gov Bailey Speaks	--	--	--	!!!
UK	19:00	MPC Member Haskel Speaks	--	--	--	!!
US	19:00	Beige Book	--	--	--	!!
EC	19:00	ECB President Lagarde Speaks	--	--	--	!!
US	22:30	FOMC Member Mester Speaks	--	--	--	!!
US	23:30	FOMC Member Bowman Speaks	--	--	--	!!

Source: Bloomberg