Risk-sensitive currencies are on the march and the dollar is retreating after US inflation cooled in May, reducing the impetus for tighter monetary policy.
The Bureau of Labor Statistics yesterday said headline prices climbed 4 percent in the year through May, down sharply from 4.9 percent in April and well below the 9.1-percent peak reached last June. The so-called “supercore” measure – which excludes highly-volatile food, energy, goods, and housing prices – climbed just 0.24 percent month over month, broadly in line with long-term pre-pandemic averages.
Markets are firmly positioned for a “hawkish hold” in this afternoon’s Federal Reserve meeting. Policymakers are expected to forego raising rates for now, instead using updated statement language, new quarterly economic projections (the notorious “dot plot”), and jawboning during the post-meeting press conference to push a “higher for longer” narrative that keeps probabilities on a July hike relatively elevated.
There are risks on both sides. Disinflationary dynamics appear to be growing more powerful and monetary policy lags mean previous tightening efforts haven’t necessarily hit growth and employment yet – so some officials are likely to stick with a wait-and-see attitude in the months to come. But economic conditions – particularly those measured in sentiment indices – seem to have improved in recent weeks, and some policymakers may wish to follow the Bank of Canada’s lead in lobbying for a more aggressive approach.
But a perceived diminishment in monetary policy uncertainty is broadly supporting risk appetite, helping yield-sensitive currencies outperform their safe-haven brethren on foreign exchange markets. If historical seasonal patterns can extrapolated forward (highly debatable), lower volatility expectations could sustain momentum in pushing the dollar lower through the summer months – but all bets are off when the darker days of autumn are upon us.
The pound is building on Tuesday’s gains after a data update showed the economy recovering in April, reversing losses suffered in the prior month. The Office for National Statistics said gross domestic product expanded 0.2 percent in April after contracting -0.3 percent in the prior month, with consumer spending helping offset ongoing weakness in the construction and manufacturing sectors. Investors think the Bank of England is likely to respond to persistently-strong wage inflation pressures and relative economic stability with additional monetary tightening, pushing toward a 6-percent terminal rate in the coming months. This short-term yield outlook is helping support the pound, even as the odds on an eventual rate-induced downturn continue to climb.
Market participants are virtually certain the European Central Bank will deliver a quarter-point hike tomorrow morning – and once again in July – but are less confident on the outlook for later in the year. Some expect officials to begin cutting rates later in the year as inflation pressures subside and growth remains anemic, while others – including ourselves – think President Lagarde’s recent “cruising altitude” language should be taken seriously, with policy likely to remain tight even as the economy softens. The accompanying forecast updates will be examined closely for guidance.