Sterling boosted by hawkish BOE

Important calendar events

• EUR: German Trade Balance, French Industrial Production, Spanish Unemployment Change, Unemployment Rate
• GBP: Final Services PMI
• USD: Average Hourly Earnings, Non-Farm Employment Change, Unemployment Rate, Final Services PMI, ISM Services PMI, Treasury Currency Report

USD

The dollar plummeted on Thursday after markets had time to digest Wednesday’s Fed rate decision, with the dollar index dropping to the 106.1 level. US bond yields continued to decline, with the US 10-year bond yielding approximately 4.66%. 

On Wednesday, FOMC members voted to keep interest rates unchanged at a 22-year high within a target range of 5.25% to 5.50%. A pause in rate hikes was widely anticipated, however, and had already been priced in by markets. 

Fed Chair Jerome Powell’s speech after the conclusion of the meeting had hawkish undertones, however, boosting the dollar. Powell admitted that the full effect of tightening is yet to be felt and although it is putting pressure on economic activity, the Fed’s hawkish policy is bringing inflation down. However, he stated that the Fed is still not confident that the current interest rates will be restrictive enough to achieve the central bank’s 2% inflation goal and warned that another rate hike in December is not out of the table. The Fed’s approach remains largely data-driven and will depend on how fast inflationary pressures may ease in the next months. 

Markets, however, were not convinced that the Fed intends to resume its tightening cycle. The probability of another rate hike within the year is still low, around 20% despite Powell’s hawkish stance, as markets discounted the Fed’s tightening bias.

Powell was careful not to communicate an end to rate hikes too early. The Fed relies on high treasury yields to complement its firming policy. If the Fed signals that it has reached its rate ceiling, markets may start pricing in rate cuts, driving yields down. This will, in turn, force the Fed to step in and increase rates again. The Fed may decide to end rate hikes completely, but interest rates are likely to remain in restrictive territory for longer.

The US economy is recovering, boosting the dollar. Advance GDP data for the third quarter of 2023 showed that the US economy expanded by 4.9%, against expectations of 4.5% growth and far surpassing the 2.1% growth of Q2. Advance GDP price index for the 3rd quarter of the year reached 3.5%, exceeding expectations of a 2.7% print. 

Core PCE Price Index, which is the Fed’s preferred inflation gauge, rose by 0.3% in September, in line with expectations. Core PCE Price Index dropped to 3.7% year-on-year in September from a 3.8% print the previous month. Inflationary pressures in the US are easing, reinforcing that the Federal Reserve will not have to raise interest rates further. US headline inflation in September, however, remained at August's levels of 3.7% year-on-year, while market analysts were expecting a drop to 3.6%. 

Important data for the US employment and services sectors are due on Friday and may affect the price of the dollar in the wake of Wednesday’s rate decision.

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EUR 

The EUR/USD edged higher on Thursday as the dollar retreated, with the currency rate climbing to the 1.061 level. If the EUR/USD pair declines, it may find support at 1.052, while resistance may be encountered near 1.069. 

Manufacturing PMI data were released on Thursday for some of the Eurozone’s leading economies and the EU as a whole. The manufacturing sector in the EU is ailing, as confirmed by Thursday’s data. Manufacturing PMI for the Euro area in October remained at 43.1, with a print below 50 denoting industry contraction. The manufacturing sector is shrinking rapidly, highlighting the fragile state of the EU economy.

The economic outlook of the Eurozone appears to be deteriorating, putting pressure on the Euro. Preliminary GDP data for the Euro area showed that the Eurozone economy contracted by 0.1% in the third quarter of the year against expectations of stagnation. The Eurozone economy barely expanded in the second quarter by 0.1%, after contracting by 0.1% in Q1 of 2023. The EU economy is struggling and cannot withstand much further tightening. 

Headline inflation in the Eurozone fell to its lowest level in two years in October, mainly due to a drop in energy prices. Flash CPI cooled to 2.9% year-on-year in October from 4.3% in September against expectations of a 3.1% print. Core CPI Flash Estimate, which excludes food and energy, was in line with expectations. Core CPI eased to 4.2% year-on-year in October from 4.5% in September. The ECB’s efforts to curb inflation rates are paying off, even at the cost of decreased economic growth.

The ECB policy rate announcement last week held few surprises. The ECB decided to keep interest rates unchanged at 4.50%. The pause in rate hikes was widely expected and market reaction was somewhat muted. The Euro dipped even further after the rate announcement, as markets expect that the ECB has hit its rate ceiling, putting pressure on the Euro. 

The ECB is tasked with assessing the risk to the fragile Eurozone economy against high inflation rates. In its monetary policy statement, the ECB indicated that inflation will likely remain high for a long time. The central bank, however, stressed that interest rates have already been raised to high levels, and will continue to be transmitted into financing conditions.

ECB President Christine Lagarde, speaking at the end of the monetary policy meeting has hinted at an end to rate hikes. Lagarde highlighted the risks to the Eurozone economy stressing that the economy is likely to remain weak for the remainder of the year. Lagarde also stated that it is too early to talk about rate cuts and warned that interest rates will remain at sufficiently restrictive levels for as long as necessary.

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GBP

The Sterling gained strength on Thursday after the BOE’s monetary policy decision. The GBP/USD rate edged higher on Thursday, touching the 1.222 level. If the GBP/USD rate goes up, it may encounter resistance near 1.228, while support may be found near 1.206. 

The BOE maintained its official rate at 5.25% on Thursday, which was in line with expectations. Thursday’s decision to keep interest rates the same was not unanimous though, with 6 MPC members voting to keep interest rates the same and 3 members voting in favor of a 25bp rate hike. MPC members had also voted in favor of a pause in rate hikes in September, but only two members had voted in favor of a rate hike then. 

The BOE has likely reached its rate ceiling but will keep interest rates on hold for a long time to bring inflation down. Even though the BOE kept interest rates the same, Thursday’s voting was interpreted by markets as slightly hawkish, boosting the Sterling.

Recent fundamentals have shown that the British economy remains fragile, reinforcing the notion that the BOE has reached its peak interest rates. Prolonged tightening has taken its toll on the labor market and other vital economic sectors.

The British economy continues to struggle, registering only nominal growth. GDP data revealed that Britain’s economy only partially recovered in August after a sharp drop in July. The British economy expanded by 0.2% in August from a 0.6% contraction in July, in line with expectations. 

Quarterly GDP data have shown that the British economy expanded at a higher pace than anticipated, expanding by 0.3% in the first three months of the year. GDP data for the second quarter of the year indicated a 0.2% expansion. More importantly, the UK's economy has grown by 1.8% since the pandemic started, beating the previous estimate of a 0.2% contraction.

BOE Governor Andrew Bailey has stated that the central bank will be watching closely to see if further rate hikes are needed. Bailey has also emphasized that the BOE will be holding interest rates in restrictive territory long enough to see inflation down to the bank’s 2% target.

British Inflation is not cooling down fast enough, despite the BOE’s consistently hawkish policy. Headline inflation remained at 6.7% year-on-year in September, the same as in August, against expectations of a drop to 6.6%. 

A combination of a struggling economy and high inflation is making the BOE’s task more difficult. Further tightening is needed to bring inflation down at the risk of tipping the British economy into recession. 

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JPY

The Yen plummeted on Tuesday after the BOJ monetary policy meeting and the USD/JPY rate skyrocketed to the 151.7 level, its highest value since October 2022. The USD/JPY rate eased somewhat later in the week but remained above the key 150 level. The USD/JPY rate remained flat on Thursday, oscillating around the 150 level, despite the dollar’s weakness. If the USD/JPY pair declines, it may find support near 148.8. If the pair climbs, it may find resistance at 151.9.

On Tuesday, the BOJ maintained its short-term interest rate target steady at -0.10% and that for the 10-year government bond yield around 0% set under its yield curve control, but redefined the 1.0% limit as a less restrictive ceiling rather than a rigid cap. Even though the BOJ tweaked its yield curve control policy slightly on Tuesday, markets were expecting a bigger shift in policy, and the Yen plummeted after the interest rate announcement. 

The BOJ has so far maintained its dovish bias, putting more pressure on the Yen as other major central banks, and especially the Fed, have raised interest rates to high levels. BOJ Governor Kazuo Ueda had lately hinted that the Central Bank may finally pivot to a more restrictive policy but has so far failed to meet market expectations. Tuesday’s slight tweak in yield curve control was interpreted by markets as “too little, too late” and failed to appease investors. 

In addition, Japanese Prime Minister Fumio Kishida is preparing to announce a 21.8 trillion Yen stimulus package to promote economic growth according to a report by Bloomberg. Further economic easing is likely to leave the Yen even more vulnerable.

Japanese authorities have been repeatedly warning speculators against excessive short selling of the Yen and have stepped in several times in the past year to provide support for the Yen. Market participants were concerned that another intervention may bring the currency rate down forcibly and were hesitant to bid excessively against the Yen. On Tuesday, however, the Japanese Ministry of Finance finally admitted that it was not involved in the Yen’s recent surges, which were probably the result of trading algorithms. The news that the Japanese government did not move to support the Yen a few weeks ago made traders bolder on Tuesday, and the Yen collapsed to a yearly low.

National Core CPI dropped to 2.8% in September from 3.3% in August. Inflation in Japan has remained above the BOJ’s 2% target for more than a year, encouraging the BOJ to tighten its monetary policy. 

Final GDP data for the second quarter of the year showed that the Japanese economy expanded by 1.2%, disappointing expectations of 1.4% growth. The final GDP Price Index showed a 3.5% annual expansion, versus 3.4% the previous quarter. Japan’s economic recovery increases the odds of a hawkish pivot in BOJ’s monetary policy.

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Written by:
Myrsini Giannouli

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