Interest Rate Decisions

Discussion and Analysis by Grace Gliksten:


The interest rate is a monetary policy tool used by central banks to manipulate the macroeconomy. Representing both the reward for saving and the cost of borrowing, interest rates can manipulate the attractiveness of prospective domestic currency exposures.


Unsurprisingly, the Bank of England decided not to raise interest rates this month. They decided instead to develop their answer to the questions surrounding when the next hike will be, saying that earlier rate hikes should be expected to curb the effects of a strong global economy on the UK. The statement, appearing hawkish, said that the central bank was no longer willing to tolerate inflation above its targeted 2%. This was repeated in a letter to the chancellor, with Mark Carney, BoE governor, saying that “monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report”, if the bank’s predictions were correct.

The language used in the press conference following the speech mirrored that used in September’s Monetary Policy Committee minutes. This was followed, immediately, by a rate hike to 0.5%, leading investors to expect a rate increase as early as May. There have been no specifics, in either the minutes or the letter to the chancellor, on what the bank felt was now needed in terms of the number, and size, of rate rises. However, Carney previously called for two to three further rate hikes in the next three years. This looks most likely to change due to the fact that inflation would overshoot the BoE’s target if there was only one rate hike a year for the next three years.

The Federal Reserve in the United States, is likely to raise interest rates much faster than the market had previously expected this year. The anticipated rise to 3.25% by year end considerably exceeds the 3% that was priced into the market only one year ago. Surpassing market expectations once again, ratings agency ‘Fitch’ forecasts four hikes in 2018; as much as double what the dominant market expectations previously predicted.

James McCormack, who oversees Sovereign ratings at Fitch, said “our impression of the Fed is that it wants to get on with this, and the rationale for leaving rates lower for longer disappeared. It will take something unexpected to interrupt the path of higher interest rates. We are not anticipating that, so we expect rates to move higher than the market expects they will.” He added, “at some point, the risk of doing too little is greater than the risk of doing too much.”

Despite all the positive news surrounding rate hikes in the US, the equities sell off this week has projected the market’s less optimistic view of the Fed’s activity. Markets are now pricing in three rate hikes to a threshold beyond the 50th percentile. March is still a big contender for the first hike, priced in at 71.9%. June, however, is looking far less likely to be the second hike, dropping from 60% to 50.3% within one day. The front loading of expectations has led September to become the biggest contender, with markets pricing in an interest rate hike that month by 72.9%. The outlook for the third hike is much more bleak, with December down to 44.3% from a previous 63%.

The European Central Bank’s position is much easier to predict, with President Mario Draghi confirming interest rates will be kept at 0.25% until their quantitative easing program has been fully tapered. Recent comments from ECB officials have signalled to investors that QE will be cut faster than expected.

Derived from an increased confidence in the recovery of the global economy, more hawkish signals came from the ECB’s December rate-setting meeting minutes. With its characteristically subtle language, the repricing of expectations was largely led by a semantic change of discussion of the Union’s “recovery” to the Europe’s “expansion”. Minutes also made very clear that the council was already reassessing the economy’s “robust and self-sustaining” expansion.

The pound strengthened against the Euro and the US Dollar following the BoE’s decision not to raise rates. Against the Euro, the Pound rose by over 1%, trading at highs of over 1.1430, before dropping off slightly to levels closer to 1.1370. Against the US Dollar, the Pound rose by over 1.5% to highs of 1.4060, again, before moving down to levels closer to 1.1391.



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Tumultuous Dollar


The weekend did not arrive without a fight, particularly for the US Dollar. The labour market in the US, and economic impressions of it, had been argued to be the only potential saving grace of the ailing Dollar. The all-important payrolls report was published on Friday providing a detailed snapshot of the labour market in the United States for January. Critically, the release included wage inflation; a variable with the salience to move the Dollar considerably.


Late last week, the ECB’s Ewald Nowotny, the Austrian central bank president, surprised markets with unmistakably hawkish comments. Nowotny suggested the ECB’s bond purchasing programme may be unnecessary, providing helpless stimulus and leading only to crowding out and eventual inflationary pressure. The hawkish comments translated into an interesting performance for the Euro last week.


In the UK, there has emerged a credible case for over valuation. Sterling is finding a tailwind despite a slew of pessimistic Brexit headlines and underwhelming economic data. This is leading investors and analysts alike to the conclusion that the Pound, for better or for worse, has a growing set of admirers.



Sterling Briefing: Pound Resillience


The Pound Sterling has proved resilient to virtually everything that the global political economy has thrown at it over the last week. The graph below highlights the performance of the Pound Sterling against a collection of its developed market peers. The illustrations highlight the points at which challenging politics or economics have seriously threatened the Pound. At each point, marked by the vertical markers, the overarching trend for the Pound has remained consistently bullish.


The green marker demonstrates the Pound’s ambivalence towards high salience soft data; the purchasing managers’ index. On Thursday, 01st February, the economic confidence and outlook-based index showed a deterioration of overall sentiment within the manufacturing industry. Whilst the initial reaction was somewhat negative, the Pound shook off the bad news and continued on an upward trend, despite the unilateral movements of the Euro and the Swiss Franc.


The orange marker exemplifies the Pound’s ignorance towards politics and, crucially, Brexit. Last Wednesday, 31st January, saw the EU explicitly reject a Brexit trade deal for UK financial services. Whilst the EU’s Brexit negotiators denied the UK’s hopes of a bespoke, finance-friendly trade deal inclusive of passporting rights, the Pound did suffer. However, the bearish market barely survived the day. Sterling markets rapidly reversed their losses without any amelioration of the pessimistic and punitive news that caused its initial decline.


This week, the Pound’s performance will be tested immensely. A Bank of England rate decision later this week will challenge traders’ sentiment regarding Sterling. On the political side, Brexit negotiations formally begin once again tomorrow, suggesting that the Pound could have a volatile week amidst high salience discussions.



Euro Briefing: Taper hopes


Eurozone data has been strong, suggesting a healthy underlining monetary union. However, data alone are not the reasons for the Euro’s strength. Instead, the interpretation of the Eurozone economy by Austrian Central bank president and ECB policy-setter, Ewald Nowotny, following his press conference in Vienna moved markets:


Nowotny suggested that the asset purchase program, or quantitative easing, could be left to expire as soon as this year, 2018. This remains a hawkish sentiment given that the present forward guidance of the ECB suggests that bonds will be purchased “at least” until September.


Nowotny’s comments echo his French colleague on the Executive Board of the ECB, Benoit Coeure, generating an image of Eurozone monetary policy that could finally tighten. Total assets under the asset purchase program and other monetary instruments now stand close to four trillion Euros making the withdrawal of monetary stimulus and balance sheet normalisation incredibly salient for the Euro.


The Euro gained around 1% against the US Dollar last week, rising above 1.25 for the first time in three years. Against the Pound Sterling, the GBPEUR cross clawed back from its weekly highs of 1.1450 to close the week at 1.1350. President Draghi will speak before the European Parliament today in an outstanding event to qualify the view of the economy expounded by Nowotny and Coeure.



Dollar Briefing: More pay; More jobs


Friday’s data release and labour market report showed an astounding performance within the US labour market. Non-farm payrolls indicated that two hundred thousand jobs had been created in January, surpassing estimates of 180,000 and a December estimate of 160,000. Despite the new jobs created, the increase was insufficient to alter the headline unemployment rate which remained firm at 4.1%.


Critically, the report did reveal an increase in wage growth; a fundamental variable intrinsically linked to economic growth and the rate of inflation. Average hourly earnings on a year-on-year basis rose by 2.9%; throwing aside expectations of 2.6% and December’s figure of 2.7%.


Wage inflation affords policy makers in the Federal Reserve an excuse to tighten monetary policy further. Around the event, therefore, the median expectation for the number of interest rate hikes in 2018 ticked up from three, to four hikes. The US Dollar appreciated as these expectations were repriced into the greenback. While the Dollar climbed, the yield on US treasuries rose; pricing in higher expectations of inflation and tighter monetary policy.





Discussion and Analysis by Charles Porter



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