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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 bounces after sharp loss; euro retreats on Lagarde comment

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Investing.com – The US dollar edged higher Monday, rebounding after the sharp losses at the end of last week on signs of cooling inflationary pressures, while the euro slipped following dovish comments from ECB head Christine Lagarde.

At 05:00 ET (10:00 GMT), the Dollar Index, which tracks the greenback against a basket of six other currencies, traded 0.4% higher to 107.750, after falling sharply from a two-year high on Friday.

Dollar bounces after sharp retreat

The dollar bounced Monday after falling sharply on Friday as the Federal Reserve’s preferred showed moderate monthly rises in prices, with a measure of underlying inflation posting its smallest gain in six months. 

That eased some concerns about how much the may cut in 2025, which had risen following the hawkish US rate outlook after the last Fed policy meeting of the year.

That said, traders are pricing in 38 basis points of rate cuts next year, shy of the two 25 bp rate cuts the Fed projected last week, with the market pushing the first easing of 2025 out to June, with a cut in March priced at around 53%.

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

Eurozone “very close” to ECB inflation goal

In Europe, fell 0.1% to 1.0414, near a two-year low it touched in November, down 5.5% this year, after European Central Bank President said the eurozone was getting “very close” to reaching the central bank’s medium-term inflation goal.

“We’re getting very close to that stage when we can declare that we have sustainably brought inflation to our medium-term 2%,” Lagarde said in an interview published by the Financial Times on Monday.

Earlier in December, Lagarde had said the central bank would cut interest rates further if inflation continued to ease towards its 2% target, as curbing growth was no longer necessary.

The lowered its key rate last week for the fourth time this year, and is likely to cut interest rates further in 2025 if inflation worries fade.

traded largely flat at 1.2571, after data showed that Britain’s economy failed to grow in the third quarter, adding to the signs of an economic slowdown.

The Office for National Statistics lowered its estimate for the change in output to 0.0% in the July-to-September period from a previous estimate of 0.1% growth.

The ONS also cut its estimate for growth in the second quarter to 0.4% from a previous 0.5%.

policymakers voted 6-3 to keep interest rates on hold last week, a bigger split than expected, amid worries over a slowing economy.

Yuan hits one-year high

In Asia, rose 0.2% to 156.72, after rising as far as 158 last week following dovish signals from the .

The BOJ signaled that it was not considering interest rate hikes in the near-term despite a recent pick-up in inflation, and could raise rates by as late as March 2025.

edged 0.2% higher to 7.3080, hitting a one-year high as traders continued to fret over China’s economic outlook. While Beijing is expected to ramp up fiscal spending in the coming year to support the economy, looser monetary conditions are expected to undermine the yuan.

 

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Asia FX muted, dollar slips from 2-yr high on soft inflation data

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Investing.com– Most Asian currencies moved little on Monday, while the dollar steadied from a tumble from over two-year highs after soft U.S. inflation data spurred some hopes that interest rates will still fall in 2025. 

Asian currencies were nursing steep losses against the dollar from last week, although they trimmed some declines on Friday after the soft inflation data. The outlook for regional markets also remains clouded by uncertainty over U.S. interest rates and policy under incoming President Donald Trump. 

Dollar slips from 2-yr high as PCE data misses expectations 

The and both steadied on Monday after clocking sharp losses on Friday.

The greenback slid from an over two-year peak after data- the Federal Reserve’s preferred inflation gauge- read softer-than-expected on Friday. 

Still, the reading remained above the Fed’s 2% annual target, keeping uncertainty over interest rates in play.

The Fed had cut interest rates by 25 basis points last week, but flagged a slower pace of interest rate cuts in the coming year, citing concerns over sticky inflation and resilience in the labor market. 

The Fed is expected to cut rates twice in 2025, although the path of rates still remains uncertain.

Markets took some relief from the government avoiding a shutdown after lawmakers approved an eleventh-hour spending bill.

Asia FX pressured by rate uncertainty 

Despite clocking some gains on Friday, most Asian currencies were still trading lower for December, as the outlook for interest rates remained uncertain.

The Japanese yen’s pair rose 0.1% to around 156.59 yen, after rising as far as 158 yen last week following dovish signals from the Bank of Japan.

The BOJ signaled that it was not considering interest rate hikes in the near-term despite a recent pick-up in inflation, and could raise rates by as late as March 2025. 

The Chinese yuan’s pair rose 0.1%, hitting a one-year high as traders continued to fret over China’s economic outlook. While Beijing is expected to ramp up fiscal spending in the coming year to support the economy, looser monetary conditions are expected to undermine the yuan. 

The Singapore dollar’s pair was flat ahead of inflation data due later in the day, while the South Korea’s won’s pair rose 0.3%.

The Australian dollar’s pair rose slightly after sinking to a two-year low last week. 

The Indian rupee’s pair steadied after hitting a record high of over 85 rupees last week.

 

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Dollar to weaken less than expected next year: UBS

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Investing.com — The dollar recently notched fresh year-to-date highs against its rivals and is likely to remain strong after the Federal Reserve leaned more hawkish at its recent December meeting, analysts from UBS said in a recent note.

“While we still expect the dollar to fall, we now see less weakness in 2025 given these factors and adjust our forecasts slightly,” analysts from UBS said in a recent note.

The less bearish view on the USD comes in the wake of the greenback making fresh year-to-date highs in key exchange rates and the expectations for fewer U.S. rate cuts. 

“The USD has been driven lately by prospects of fewer Fed rate cuts and tariff risks,” the analysts said.

The euro has been particularly affected by dollar strength, but is expected to trade around $1.05 against the greenback in the first half of 2025, the analysts forecast. 

But a significant drop toward parity for the can’t be ruled out, “due to real tariff threats or further divergence in the macro backdrop between the US and Europe,” the analysts added.

Still, any move toward parity should be short-lived, the analysts said, amid expectations for the economic backdrop in Europe to improve in the second half of the year, narrowing the divergence between Europe and U.S. yields. 

“The trajectory back into the middle of the trading range or higher, 1.08 to 1.10, comes with the view that two-year yield differentials will still narrow to some degree and better macro data out of Europe provide some underlying support for EURUSD in 2H25,” the analysts said.

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