Will BoE be the next G10 central bank to deliver hawkish policy surprise?

USD/CNY: China stimulus & geopolitical risks in focus

The US dollar has continued to trade at weaker levels during the Asian trading session  following last week’s sell-off. The US dollar weakened against all other G10 currencies last week with the exception of the yen which was the worst performer. US dollar weakness was most evident against the pound (+2.4% vs. USD), Norwegian krone (+1.9%), euro (+1.6%) and Swiss franc (+1.6%). It has helped to lift cable to a fresh year to date high of 1.2848, and EUR/USD back up towards the top of its trading range for most of this year between 1.05000  ad 1.1000. The renewed period of US dollar weakness has coincided with building speculation over the prospect of further policy stimulus in China in response to the loss of growth momentum in Q2. The PBoC has already started to lower rates (the OMO and MLF rates last week) and further cuts are expected as soon as this week (the loan prime rate). China’s cabinet also proposed a series of new policies to promote sustained economic recovery at an executive meeting chaired by Premier Li Qiang on Friday. The cabinet members said stronger measures must be taken to enhance growth momentum, and they proposed measures to improve macroeconomic policies, expand effective demand, strengthen and optimize the real economy, and prevent and resolve risks in key fields.  Market participants are now eagerly waiting to see what further stimulus measures will be rolled out to support growth. The strength of the economic recovery in China during the second half of this year will be important for the performance for Asian, commodityrelated and emerging currencies going forward. Market participants are also closely watching to see if this week’s trip by US Secretary of State Antony Blinken to China helps to ease or at least stabilize geopolitical tensions between the two countries. Antony Blinken is the most senior US official to visit China in five years. According to Bloomberg, there is no expectation going into talks today that the US and Chinese delegations would reconcile any of their fundamental differences. The previous day’s dialogue had, however, improved the two sides’ understanding of each other and pushed talks toward a better outcome.    

One of the important risk events for the US dollar in the week ahead will be the semiannual monetary policy testimony from Fed Chair Powell to Congress delivered on Wednesday and Thursday. We expect Chair Powell to deliver a similar message to the one at last week’s FOMC meeting. The Fed was clear that they now felt they could slow the pace of hikes but that the decision to skip a hike this month did not mean the hiking cycle was over. The updated dot plot revealed that the majority of FOMC members now favour delivering two more hikes by the end of this year and lifting the key policy rate to a peak of closer to 5.50%. Yet the US rate market is still not convinced that the Fed will deliver two more hikes and is currently pricing in only around 21bps of further hikes by September. However, we do not expect Chair Powell to push back hard against those expectations in his testimony this week. While there is a higher risk now of another hike in July, the incoming economic data over the summer period will determine whether the Fed delivers a second hike later this year. We continue to believe that building evidence of disinflation pressures will discourage the Fed from following through on current plans to deliver two more hikes, and see room for the US dollar to weaken further as the Fed becomes less hawkish.   

USD IS STILL REVERSING UKRAINE CONFLICT GAINS VS EUR & GBP

Source: Bloomberg, Macrobond & MUFG GMR

GBP: How long will the GBP continue to outperform?

It has been another good week for the GBP which hit hit fresh year to date highs last week against the other major currencies of the USD, EUR and JPY.  It extends the GBP’s bullish run that has been in place since early in March. The GBP has been the best performing G10 currency since 8^th  March when it has strengthened by 8% against the USD, 4% against the EUR and 11% against the JPY. The GBP’s bullish trend is being encouraged by expectations for a more extended BoE tightening cycle. With the exception of the brief dip lower in the middle of March when the US regional banking crisis first emerged, UK yields have adjusted sharply higher during this period of GBP outperformance. The yield on the 2-year UK Gilt yield has risen by around 1.10 percentage points since 8th March hitting a fresh cycle high of 4.97% today. More importantly for the FX market, the move higher in UK yields stands in marked contrast to the adjustment lower in yields in other major economies. For comparison, the 2-year US Treasury bond yield has fallen by around 0.50ppt over the same period, the 2-year euro-zone government bond yield has fallen by around 0.20ppt, and the 2-year JGB yield has fallen by  around 0.03ppt. It has resulted in yield spreads moving sharply in favour of a stronger GBP.

Market expectations for more aggressive BoE rate hikes will be tested in the week ahead by the release of the latest UK CPI report for May (Wed) and MPC meeting (Thurs). In light of the recent repricing, the hurdle for another hawkish surprise that triggers another leg higher for UK rates and the GBP in the week ahead is arguably much higher now. It will be hard for the BoE’s policy update to fully meet market expectations for a further 125-150bps of hikes. It would likely require the BoE to revert back to delivering a larger 50bps hike or to provide a hawkish signal that a larger 50bps hike is a more realistic possibility at the following MPC meeting in August when policymakers will be able to better assess the inflation outlook alongside the updated Monetary Policy Report.

The surprising resilience of the UK economy and stronger wage growth are increasing concerns over the persistence of higher inflation in the UK, and should encourage the BoE to deliver a hawkish policy update. Yet if the BoE only hikes rates by 25bps and does not signal it is seriously considering larger 50bps hikes, it could trigger a temporary correction lower for UK yields and modest GBP sell-off.  On its own though we doubt that would be sufficient for sustained reversal of the GBP strengthening trend. The biggest downside  risks for the GBP would be if core inflation dropped more than expected in this week’s CPI report, and the BoE pushed back strongly against how many rate hikes are currently priced into the UK rate curve. We view that as a low probability risk in the week ahead but it could have a bigger negative impact on GBP performance if it materializes. Please see our latest FX Weekly report for more details (click here).      

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
SZ	09:00	Total Sight Deposits CHF	Jun -16	--	509.8 b	!
EC	12:00	ECB's Lane Speaks				!!!
EC	12:40	ECB's Schnabel Speaks				!!!
EC	14:00	ECB's Villeroy speaks in Paris				!!!
US	15:00	NAHB Housing Market Index	Jun	51.0	50.0	!!
EC	19:00	ECB's Guindos Speaks				!!

Source: Bloomberg