Weakness in the dollar has helped the pound to extend gains above $1.33 since the Budget bounce on Wednesday, even though it has backed off highs at the start of trading. Although on the face of it the downgrade to the UK growth forecasts and the weak productivity theoretically should be bad news for sterling, the market is most likely pricing out the probability of a collapse in the government, as Hammond’s generally well-received performance is the first solid piece of good news for Theresa May after a torrid month.
Can the pound continue to rally on the Budget alone?
The pound move is also partly technical, GBP/USD had attempted to break above the 1.3280 mark earlier this week, and finally succeeded on its third attempt, which coincided with the Budget. The pound also received a helping hand from the sharp drop in the dollar in recent days. The dollar index has crashed below its 100-day sma on Wednesay as the US heads into the Thanksgiving holiday and has made a series of lower lows this month as the Republican pledge to get tax reform done and dusted by Christmas is starting to look pie in the sky.
Notwithstanding the troubles for the dollar, the pound is also vulnerable since its recent rally has not been underpinned by Gilt support. The UK – US 10-year yield spread is still close to its lowest level in 2-months, even after Wednesday’s decline in US yields after the Fed meeting. This is one reason why the pound isn’t doing better on a broader basis, and why the pockets of weakness in the Budget have not been brushed off by EUR/GBP, which was relatively flat on Wednesday.
The yen flies high
The Japanese yen is the one to watch and it is the top performer in the G10 FX space in the last 24 hours, and USD/JPY fell below its 200-day moving average, a key bearish indicator, as the FOMC minutes from their meeting earlier this month were perceived by the market as being a touch on the dovish side, which drive USD/JPY below 112.00. Yen strength is so far failing to weigh on the Nikkei, which is the only Asian index in the green at this stage. Chinese stocks suffered their biggest fall for the year, down some 2% at the time of writing after warnings from the Chinese authorities about runaway prices. Interestingly, the Chinese authorities seem to take a different view to runaway asset prices compared to their counterparts at the Fed and BoE…
FOMC minutes put 2018 hikes into doubt
The reaction to the Fed minutes was interesting, stocks stayed lower, yields fell and the dollar declined. Although the Fed clearly signalled that a rate rise next month is on the cards, the market slightly reduced its expectations to 92% from 97% a week ago. There remains an on-going debate around the outlook for inflation with some FOMC members looking for further price gains before they are comfortable with the outlook for prices, which could impact rate increases in 2018.
There has been a decline in expectations for rate rises next year, with only one hike actually expected in 2018, which would push US interest rates to a peak of 1.75%. Without rate support the dollar is coming undone, while stocks, which usually react well to low rates, are coming under pressure as a cautious Fed could signal fears about the US economic outlook next year. If we are to continue to see US stocks rise into year-end then progress from Washington on the tax-reform front is essential in the next few weeks.
Is US inflation really that weak?
Of course, Yellen is leaving in February and the outlook for prices could always change, which could put the prospect of further rate hikes on the cards for next year. It is worth noting that the University of Michigan survey of inflation expectations 1-year out remains above the Fed’s target rate at 2.5%, and has held steady even in the face of weak price pressure this year. Thus, the dollar and US stocks are likely to be sensitive to any inflation-related data releases in the coming weeks.
Some key data points
Ahead today, watch out for final GDP for Q3, which is expected to remain stable at 1.5%, and the CBI reported retail sales for November, which is the first check we have of the retail sector’s health at the start of the Christmas shopping season. A weak reading or a downgrade to GDP could send the pound back below 1.33.
Eurozone PMI reports for November are also worth watching, a decent number could push EUR/USD above the 1.1880 top from October. The US is out for Thanksgiving, so we expect a very quiet afternoon session.
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