Reuters report triggers a brief relief rally for the EUR

USD: Fed set to upgrade GDP & lower core inflation forecasts for this year

The US dollar is continuing to trade close to recent highs ahead of today’s FOMC meeting after the dollar index hit an intra-day high last week at 105.44. While the Fed is not expected to change their policy rate today, the US rate market has been scaling back expectations for rate cuts in 2024 ahead of today’s FOMC meeting that has helped to lift short-term US rates. The 2-year US Treasury yield hit an intra-day high yesterday of 5.11% which is just below the July high at 5.12%. The amount of Fed cuts priced in by the end of next year has fallen to around -70bps. There were no major US economic releases yesterday. Rather it was the release of the much stronger Canadian CPI report for August that appeared unusually have to have some spill-over impact on the US Treasury market. The report triggered a bigger hawkish repricing in the Canadian rate market after revealing further evidence that  core inflation has picked up in recent months. Over the last three months, the annualized measures of core inflation have increased by 4.5% in August. It is more bad news for the BoC who have clearly signalled concerns recently that the core inflation had been coming down more slowly than they wanted and was holding above 3.5%. The report has encouraged the Canadian rate market to price in a higher probability of one final hike from the BoC at the end of this year or in early 2024. There is now 29bps of hikes priced in by March of next year. The hawkish Canadian rate market pricing in response to the latest CPI report is a further supportive development for our short GBP/CAD trade idea recommended in our latest FX Weekly report (click here).

There should be no clear implications for the Fed policy outlook from the Canadian CPI report, US rate expectations should be impacted more by the latest FOMC meeting tonight. Our US rate strategist expects the Fed to deliver a hawkish hold that keeps alive the option to hike again later this year but also reduces the number of planned cuts in 2024. The median terminal rate for 2023 is expected to remain at 5.625%, and there is a risk that the 2024 median terminal rate moves higher to 4.875% if submissions rise to suggest higher for longer rates ahead. At the same time, the Fed will release projections for 2026 for the first time. We expect the 2026 median projection for the Fed funds rate to look more like the longer-run dot at around 2.9%. Market participants will also be watch closely to see if the longer-run median projection for Fed funds rate is raised from around 2.5 where it has remained since pre-pandemic given it is viewed as a proxy for r* which the Fed’s estimate of the longer run neutral policy rate. There has been speculation amongst market participants recently over a higher neutral policy rate given the resilience of the US economy so far this year to higher rates. The developments should be supportive for a stronger US dollar. The main risk would be if the Fed pulls plans for one final hike and Chair Powell signals more strongly that the hiking cycle is now over.

GBP IS GIVING BACK GAINS FROM THE 1H OF THIS YEAR

Source: Bloomberg, Macrobond & MUFG Research calculations

GBP: Weaker UK CPI report reinforces case for less hawkish BoE policy update

The pound has continued to weaken at the start of the European trading session undermined by the release of the weaker than expected UK CPI report for August. It has resulted in EUR/GBP moving up towards the top of the 0.8500 to 0.8700 trading range that has been in place May, and cable has dropped below 1.2350. The main trigger for the pound’s reinforced downward momentum this morning was the release of the UK CPI report for August that revealed a bigger drop in the core rate of inflation by 0.7ppt to 6.2% as it moved further below the peak from May at 7.1%. While the core rate of inflation remains elevated it does provide some relief for the BoE ahead of tomorrow’s MPC meeting. The breakdown revealed that annual rate of goods inflation increased slightly by 0.2ppt to 6.3% while services inflation slowed by 0.6ppt to 6.8%. Outside of the core, there was also good news that food prices continued to slow to an annual rate of 13.6% in August and moved further below the high from March at 19.2%.

The softer CPI report reinforced our expectations for a less hawkish policy update from the BoE tomorrow. It may even prompt some speculation that the BoE could leave rates on hold tomorrow. The UK rate market is now pricing in around 14bps of hikes compared to around 20bps prior to the release of the CPI report indicating that another 25bps hike tomorrow is judged as a closer call. At the very least it adds to recent evidence of weaker activity data in Q3 and less hawkish comments from BoE Governor Bailey and Chief Economist Pill that were already arguing in favour of the BoE signalling tomorrow that they are close to the end of their hiking cycle. It supports our outlook for one final 25bps hike to a peak of 5.50%.    

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
CA	18:30	BOC Summary of Deliberations	--	--	--	!
US	19:00	Fed Interest Rate Decision	--	5.50%	5.50%	!!!
US	19:30	FOMC Press Conference	--	--	--	!!!

Source: Bloomberg