As Fed delivers a “hawkish” pause, attention turns to the ECB

European markets closed the day higher yesterday, with the DAX making a new record high, ahead of last night’s Fed decision, while US markets closed the session mixed after a choppy session, which saw the Fed deliver a hawkish pause to their rating hiking cycle.

Asia markets were mixed with the latest Chinese retail sales data for May coming in below expectations, rising by 12.7%, along with industrial production which gained 3.5%.

The last few weeks have delivered plenty of evidence that headline inflation is slowing sharply, and while core prices are probably stickier than the Fed would like, the direction of travel with respect to PPI suggests that in a couple of months we could be looking at a very different outlook.

Having indicated that they would be looking to hike in July, after removing the line that signalled more rate hikes were coming at the May meeting, there was always a risk that this sort of pre-commitment might turn out to be problematic. So, it has proved, with many suggesting that they would be better off hiking today, and then playing a game of wait and see.

In any case with the Federal Reserve unwilling to step back from its commitment to a pause this month, and delivering on an expectation to keep rates unchanged, they compensated for that by raising their expectation this year for at least 2 more rate hikes, putting the terminal rate at 5.6%, with 12 Fed officials, projecting such a move. 

This unexpected hawkish shift saw US 2-year yields spike sharply as the market priced out the prospect of rate cuts later this year, which was never likely anyway, however we also saw the US central bank change their forecasts for unemployment to rise to 4.1% by the end of this year, down from 4.6%, while tweaking its PCE forecast to 3.2% from 3.3%.

Unsurprisingly, the US dollar which had been in retreat, rebounded strongly and stock markets dropped back sharply, over concerns that the US central bank could be on the cusp of a policy mistake. 

Once Powell started his press conference the initial moves started to unwind and markets attempted to absorb the message from last night’s events, and whether the two more hikes guidance, was based on any type of empirical evidence, or merely a mechanism to steer market expectations, and keep last night’s decision unanimous. The tone of Powell’s press conference suggests it was the latter.

While yesterday’s post decision reaction shows that markets were caught the wrong side of last night’s decision, the bigger test will be in the economic data. If inflation continues to slow and jobs growth remains steady, the question needs to be asked as to whether the Fed will really pull the trigger on more rate hikes? It seems unlikely.

Moving on from last night’s decision, attention will now shift towards today’s ECB rate decision.

There appears to be little doubt that we will probably see another 25bps rate hike from the European Central Bank at today’s rate meeting.

Nonetheless this would be a notable shift from some of the recent narrative that has accompanied recent discussions about the likely rate path for the ECB. The change of emphasis appears to have come about because of recent sharp falls in the headline rate of CPI, as well as evidence that core prices may well have also seen a peak.

In the latest flash CPI numbers for May, headline inflation fell to 6.1%, a sharp fall from the 7% we saw in April, as well as the 9.2% we were seeing at the end of last year. The big concern in recent months has been core prices which hit a record high of 5.7% in March and fell to 5.3% in the most recent numbers released earlier this month. Based on these numbers alone one can understand the ECB’s reluctance to stop hiking, however there are already risks emerging that might suggest the ECB could be close to its own pause moment.

These risks are sharp slowdowns in PPI, which tends to act as a leading indicator for future inflation trends with German PPI now in negative territory. The German economy is also in recession, along with the rest of the eurozone, and yet various ECB policymakers are still calling for several more rate rises, including the likes of Joachim Nagel head of the German Bundesbank, due to still high levels of CPI inflation.

This comes across as particularly risky at a time when we are starting to see increasing signs of deflation across the global economy. Whatever the ECB does today, and a hike is priced in, it is what comes next which is very much up for debate, where ECB President Christine Lagarde will need to tread carefully.

Will the hawks on the ECB maintain their hawkish narrative or will see those claws start to get reined in until we get a better idea of the cumulative effect that the current spate of rate hikes has had.

Coming so soon after last nights Fed decision we get US retail sales for May and weekly jobless claims.

Retail sales for May are expected to decline by -0.2%, down from 0.4% in April, while weekly jobless claims which spiked up to 261k last week are expected to slip back to 245k.

The last time we spiked above 260k a few weeks ago it was revised away. Will the same thing happen today?

EUR/USD – Pushed above the 1.0820/30 area yesterday and closing in on the 50-day SMA at 1.0880, with resistance now at 1.0920. We still have support back at the recent lows at 1.0635.

GBP/USD – Broke above trend line resistance from the 2021 highs at 1.2630 and testing above 1.2680 with the next resistance at 1.2760, which is a key barrier for a move towards the 1.3000 area. We have support at 1.2450. 

EUR/GBP – Still looking soft despite the key day reversal day earlier this week, but still above 0.8540 support. A break below 0.8530 targets a move towards 0.8350. Resistance at 0.8620.

USD/JPY – Still trying to move through the 140.30 area with resistance behind that at the recent highs at 140.95.  Upside remains intact while above 138.30. 

FTSE100 is expected to open 10 points lower at 7,592.

DAX is expected to open 12 points lower at 16,298.

CAC40 is expected to open 15 points lower at 7,313.