Heading into this week, markets had already braced for raised volatility in expectation of two key and much awaited central bank meetings. Those two central banks that were scheduled to meet were the Bank of England and the Federal Reserve. As you will recall, there has been a theme this year to date to kick the can down the road and justify a lack of action at the central bank level based upon the need to observe evolving data. The downside to that was that central bankers were forced to at least provide some light at the end of the tunnel and speculate at which time the bank would have sufficient information to move one way or the other. Those forecasted dates are now.
As if that wasn’t enough, yesterday, whilst markets were anticipating the Federal Reserve decision later that day, scheduled at 2PM ET (7PM BST), the ECB announced an emergency meeting only a handful of days after their last scheduled meeting. This caught the market off guard because having decided to take no action with its main instruments of monetary policy only 6 days prior, markets quite rightly questioned why this bank was suddenly meeting. The timing of the decision ahead of the Federal Reserve scheduled for that evening was no accident with speculation that the ECB wanted the market to digest whatever its meeting may bring before the Federal Reserve dropped its own decision.
The ECB cited concerns over BTP spreads – the yield at which peripheral European debt (specifically Italian debt in this particular measure) trades versus the debt of core nations (specifically German in the infamous BTP measure). When borrowing costs across the European bloc diverge it creates pressure on the single currency area that the ECB wants to avoid. When the ECB announced it would be meeting, markets anticipated that BTP spreads, that had widened significantly to a post pandemic high just shy of 240 basis points, would be the key focus. Accordingly, markets began selling German Bunds in favour of Italian debt to position for the expected announcement. As this spread narrowed, the Euro also rallied versus the Dollar by almost once cent.
Ultimately, the ECB provided almost nothing, only instructing the council to look outside its mainstream policy toolkit to create a tool to maintain roughly equal financing conditions across the currency area. The Euro therefore sold off once again on the lack of action taken by the ECB. The Fed last night raised rates by 0.75%, the largest hike in 30 years. What was critical to deliver today’s USD strength was the published expectation that individual members of the Fed project rates to hit 3.8% by the end of 2023 and 3.4% by the end of this year before moderating in 2024. The Bank of England is set to deliver its own decision later today.
Discussion and Analysis by Charles Porter