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Forex

First to hike, last to cut? BoE caution cossets pound: Mike Dolan

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By Mike Dolan

LONDON (Reuters) -First to hike, first to hit its inflation target – and the last to cut?

It may be unwise to read too much into volatile and marginal interest rate bets in financial markets, but right now that’s how they sketch the Bank of England’s (BoE) policy trajectory against its major economy peers.

The pound – enthused by an expected but decisive UK election result this month – is lapping up that rate sequence most of all. And that’s perhaps one reason the BoE may be tempted to jump the market gun next month, even though there’s still only a 50% chance of that baked into the money curve.

Sterling topped $1.30 for the first time in a year this week, hit a two-year high against the euro and notched a 16-year high against Japan’s ailing yen. The BoE’s own trade-weighted sterling index is at its highest since 2016’s Brexit referendum – appreciating some 13% from the nadir of 2022’s jarring government budget farce.

Might the sheer strength of the pound be enough to force its hand?

Debate on the extent of so-called “exchange rate pass-through” to inflation has raged for years – with many different opinions on what underlying conditions make it impactful.

The clear counter-point is that BoE’s main problem right now is less about import prices or dollar-denominated energy than that it is about still-spiky domestic price inflation.

But in a split decision, the pound may nudge things along – not least if there’s concern that UK financial conditions more broadly don’t over-tighten at the wrong moment.

UK economic surprises are unusually positive right now, but global equivalents have turned sour at midyear and the exchange rate could well come into play if that presages a wider international slowdown.

FIRST IN, LAST OUT

Japan’s peculiar cycle aside, the BoE was the first of the rest of G7 to start lifting borrowing costs into the post-pandemic inflation spike in late 2021 – hiking twice before the U.S. Federal Reserve started three months later and piling 5 percentage points onto a near zero policy rate in 20 months.

Although it remains irked by annual wage gains and services price growth in excess of 5%, the BoE has this year become the first of its peer group to hit its headline 2% inflation target – where it’s been held for two months now.

And yet the jittery world of money markets still expect it to be the last of the six to execute its first cut – following not only the European Central Bank (ECB) and Canada in the G7, but the Swiss and Swedish central banks to boot.

Markets even reckon the ECB, Canada and Sweden will likely have cut a second time before Threadneedle Street will be ready to budge.

To be sure, the BoE may only lag the Fed by a day in September if it matches those rate bets. But, even then, there’s still a marginal doubt in money markets that it pulls the trigger in two month’s time, while futures are comfortable fully pricing a Fed move.

Why the caution, and does the UK really need to bookend both sides of the global cycle?

KNIFE EDGE

For decades, Britain was seen as an inflation outlier – due in part to instability in sterling and its effect on such an open economy, its poor productivity record and political control of interest rates until 1997.

BoE independence shifted the dial. But the UK’s outsize exposure to the banking crash of 2008 and then the trade and investment disruption from Brexit pummeled the pound – even if that was likely masked in domestic prices by subdued global inflation more generally.

That all changed with the post-COVID global inflation surge – and UK annual price rises topped 11% at one point, higher than the peaks in other countries.

The government budget missteps of 2022 added fiscal risk perceptions and fears for joined-up thinking between Treasury and the central bank on inflation control – compounding as it did UK vulnerability to the Ukraine-related energy shock.

Some of that has been painfully repaired since, with this month’s change of government seen by many overseas investors as a clean break.

Whether the BoE can breathe easier is now the question. For a start, public inflation expectations fell to their lowest this month since before the pandemic, possibly assuaging some BoE concerns about “persistence” in wage and services inflation.

Sterling’s rally apart, the dissipation of that latest risk factor can be seen most clearly in UK government bond markets, where the 150 basis point yield premium on five-year gilts over German equivalents is a full percentage point lower than it was at the height of the 2022 budget blowout.

Yet on the flipside, if BoE concern shifts to the dangers of staying too tight for too long, then the sight of an inflation-adjusted “real” five-year gap with Germany at its highest in 20 years may be food for thought.

With the pound now comfortably feeding off that premium rather than balking at it, the BoE might view it as a window.

A month or two may not matter greatly in the wider scheme of things, of course.

But despite hesitant money market pricing, there are plenty of economists who still expect the BoE to beat the Fed to the punch – with the likes of Barclays and Deutsche Bank tipping a rate cut next month as the central bank uses new forecasts in its latest Monetary Policy Report to explain.

© Reuters. FILE PHOTO: People stand next to the Bank of England, in London, Britain, July 7, 2024. REUTERS/Claudia Greco/File Photo

“August’s Bank Rate call is on a knife-edge,” said AXA Investment Managers’ G7 economist Gabriella Dickens, adding she expects a 5-4 policymaker vote to cut.

The opinions expressed here are those of the author, a columnist for Reuters.

(By Mike Dolan X: @reutersMikeD; Editing by Jamie Freed)

Forex

Dollar retains strength; euro near two-year low

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Investing.com – The US dollar rose in thin holiday-impacted trade Tuesday, retaining recent strength as traders prepared for fewer Federal Reserve rate cuts in 2025.

At 04:25 ET (09:25 GMT), the Dollar Index, which tracks the greenback against a basket of six other currencies, traded 0.1% higher to 107.905, near the recently hit two-year high.

Dollar remains in demand

The dollar has been in demand since the Federal Reserve outlined a hawkish outlook for its interest rates after its last policy meeting of the year last week, projecting just two 25 bp rate cuts in 2025.

In fact, markets are now pricing in just about 35 basis points of easing for 2025, which has in turn sent US Treasury yields surging, boosting the dollar.

The two-year Treasury yield last stood at 4.34%, while the benchmark 10-year yield steadied near a seven-month high at 4.59%. 

“We think this hawkish re-tuning of the Fed’s communication will lay the foundation for sustained dollar strengthening into the new year,” said analysts at ING,in a note.

Trading volumes are likely to thin out as the year-end approaches, with this trading week shortened by the festive period.

Euro near to two-year low

In Europe, fell 0.1% to 1.0396, near a two-year low, with the set to cut interest rates more rapidly than its US rival as the eurozone struggles to record any growth.

The ECB lowered its key rate earlier this month for the fourth time this year, and President Christine Lagarde said earlier this week that the eurozone was getting “very close” to reaching the central bank’s medium-term inflation goal.

“If the incoming data continue to confirm our baseline, the direction of travel is clear and we expect to lower interest rates further,” Lagarde said in a speech in Vilnius.

Inflation in the eurozone was 2.3% last month and the ECB expects it to settle at its 2% target next year.

traded largely flat at 1.2531, with sterling showing signs of weakness after data showed that Britain’s economy failed to grow in the third quarter, and with Bank of England policymakers voting 6-3 to keep interest rates on hold last week, a more dovish split than expected.

Bank of Japan stance in focus

In Asia, fell 0.1% to 157.03, after rising as high as 158 yen in recent sessions, after the signaled that it will take its time to consider more interest rate hikes. 

edged 0.1% higher to 7.3021, remaining close to a one-year high as the prospect of more fiscal spending and looser monetary conditions in the coming year weighed on the currency. 

Beijing signaled that it will ramp up fiscal spending in 2025 to support slowing economic growth. 

 

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Asia FX muted, dollar recovers as markets look to slower rate cuts

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Investing.com– Most Asian currencies moved in a tight range on Tuesday, while the dollar extended overnight gains as traders positioned for a slower pace of interest rate cuts in the coming year. 

Trading volumes were muted before the Christmas break, while most regional currencies were nursing steep losses against the greenback for the year.

Asian currencies weakened sharply last week after the Federal Reserve effectively halved its outlook for rate cuts in 2025, citing concerns over sticky U.S. inflation. 

Dollar near 2-year high on hawkish rate outlook

The and both rose about 0.1% in Asian trade, extending overnight gains and coming back in sight of a two-year high hit last week. 

While the greenback did see some weakness after data read lower than expected for November, this was largely offset by traders dialing back expectations for interest rate cuts in 2025.

The Fed signaled only two rate cuts in the coming year, less than prior forecasts of four.

Higher U.S. rates diminish the appeal of risk-driven Asian markets, limiting the amount of capital flowing into the region and pressuring regional markets. 

Asia FX pressured by sticky US rate outlook 

Most Asian currencies weakened in recent sessions on the prospect of slower rate cuts in the U.S., while uncertainty over local monetary policy and slowing economic growth also weighed.

The Japanese yen’s pair fell 0.1% on Tuesday after rising as high as 158 yen in recent sessions, after the Bank of Japan signaled that it will take its time to consider more interest rate hikes. 

The Australian dollar’s pair fell 0.2% after the minutes of the Reserve Bank’s December meeting showed policymakers saw an eventual easing in monetary policy, citing some progress in bringing down inflation. But they still flagged potential upside risks for inflation. 

The Chinese yuan’s pair rose 0.1% and remained close to a one-year high, as the prospect of more fiscal spending and looser monetary conditions in the coming year weighed on the currency. 

Beijing signaled that it will ramp up fiscal spending in 2025 to support slowing economic growth. 

The Singapore dollar’s pair rose 0.1%, while the Indian rupee’s pair rose 0.1% after hitting record highs above 85 rupees.

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Forex

Dollar breaks free, poised for more gains amid US economic outperformance

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Investing.com — The dollar has surged past its post-2022 range, buoyed by U.S. economic exceptionalism, a widening interest rate gap, and elevated tariffs, setting the stage for further gains next year.

“Our base case is that the dollar will make some further headway next year as the US continues to outperform, the interest rate gap between the US and other G10 economies widens a little further, and the Trump administration brings in higher US tariffs,” Capital Economics said in a recent note.

The bullish outlook on the greenback comes in the wake of the dollar breaking above its post-2022 trading range, reflecting renewed confidence among investors driven by robust U.S. economic data and policy expectations.

A key risk to the upside call on the dollar is a potential economic rebound in the rest of the world, similar to what occurred in 2016, Capital Economics noted.

Following the 2016 U.S. election, economic activity in the rest of the world rebounded, while Trump’s tax cuts didn’t materialize until the end of 2017, and the Fed took a more dovish path than discounted, resulting in a 10% drop in the DXY on the year, which was its “worst calendar year performance in the past two decades,” it added.

While expectations for a recovery in Europe and Asia seem far off, a positive surprise for global growth “should be ruled out”, Capital Economics said.

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