Markets Weekly podcast – 13 June 2022

Henk Potts (HP): Hello. It’s Monday, 13^th June and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for foreign exchange markets. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Last week the familiar story of surging price pressures, rising commodities, and expectations of a steeper policy path continued to crush investor sentiment. Stocks tumbled, government bond yields spiked higher, and the dollar strengthened.

In terms of market performance, the S&P 500 fell 5.1% over the course of the week, its biggest weekly loss since January and the ninth weekly drop in 10. The index is now down 14% this quarter, heading for its biggest decline since the early days of the pandemic in the first quarter of 2020.

European equity markets also fell aggressively. The STOXX 600 fell 3.9% over the course of the week and is down 7.3% in the second quarter. In bond markets, 2-year Treasury yields spiked above 3% for the first time since 2008, as rate traders start to price in more aggressive hikes from the Federal Reserve over the course of the coming months.

Hopes that US inflation had peaked in March were shattered after the consumer price index surged 8.6% in April, its fastest pace since 1981. The increase was driven by the rising costs of fuel, food, and shelter as a result of the war in Ukraine and the reopening of the economy.

Energy prices jumped 34.6% from a year earlier, which was the most since 2005, while grocery prices rose 11.9% annually, the fastest rate of increase since 1979. You can argue, in fact, the only respite for policymakers in the report was a moderation in core inflation reading.

In terms of the inflation forecast, well, we have raised our US annual inflation projection for this year to 7.7%. We do anticipate that price pressures will begin to ease down into year-end, driven by base effects, a gradual reopening in China, and the unwinding of core goods inflation. We forecast that CPI will decline to 6% at year-end and will trend lower during the course of next year to average 2.7%.

Meanwhile, the European Central Bank signalled the era of negative interest rates will come to an end over the course of the coming month. It stated that its APP purchases will be concluded on 1^st July, as the central bank dramatically pivots away from promoting growth to curbing inflation.

The ECB has been forced into the move after inflation hit 8.1% in May, the highest since the single currency was created back in 1999. Central banks’ inflation forecasts have also been revised up to 6.8% for 2022, 3.5% in 2023. Perhaps most importantly, however, core inflation is also forecast to be above 2% all the way through till 2024.

Meanwhile, its growth forecasts have been downgraded to 2.8% in 2022, 2.1% for 2023. In fact, we have a more pessimistic view of eurozone growth, which is based on weaker domestic demand due to more persistent headwinds from high inflation on households’ real income, a less resilient labour market, and a decreased willingness from consumers to draw upon savings accumulated during the course of the pandemic, while higher input costs, higher wages, tighter financial conditions, and heightened uncertainty will depress growth investment.

In fact, we think there’s a real risk of a technical recession at the turn of the year in the eurozone. We’ve slashed our growth forecast in Europe for next year to just 0.5%.

In terms of that policy path, we’re now looking for a 25 basis point hike in the July meeting. Fears of a wage pricing spiral and/or a de-anchoring of inflation expectations have encouraged members of the Governing Council to unusually pre-commit to an additional hike of at least 25 basis points at the September meeting, although we believe 50 basis points is now more likely and our current expectation is the European Central Bank will further raise rates by 25 basis points at the October meeting.

Put that all together and it suggests a deposit rate will hit half of 1% by the time that we get through the end of October. By then we think policy will be on pause as growth and inflation starts to trend lower.

What we do know is, of course, rising commodities continue to drive price pressures. Bloomberg’s Commodity Spot Index, which tracks prices of 23 raw materials, rose to an all-time high last week on expectations of a revival in demand from China.

Global commodity prices bottomed out, of course, in the early weeks of COVID and have gone on to rally 36% during the course of this year due to the rapid recovery in demand, of course, exacerbated by massive stimulus spending, along with supply disruption emanating from the ramifications of the war in Ukraine, particularly on energy and grains and reduced production investment during the course of the pandemic.

Persistently higher commodity prices, as we have been discussing, of course, has negative ramifications for inflation projections but also for food security and social stability particularly in developing economies.

So that was the global economy and financial markets last week. In order to discuss the outlook for foreign exchange markets I’m pleased to be joined by Bhaskar Gupta. He’s Head of FX Distribution with Barclays Private Bank.

Bhaskar, good to have you with us today. Can you start by taking us through how FX markets have performed so far during the course of this year and what have been the key drivers behind those movements?

Bhaskar Gupta (BG): Hello, Henk, and thanks for having me on the call. Well, the FX markets have been very interesting of late, to say the least. While the last few weeks have been a bit range-bound. In G-10 world, we have seen some significant moves, significant directional moves over the last three months, after a relatively quiet 2021. And, I say quiet only from an FX perspective, the markets almost, like, woke up from slumber if I may say.

This was triggered by a wave of, like you’ve mentioned just now, a global inflation wave that spiralled out of control. After decades of low inflation, we are now seeing inflation numbers of 8% and above with no sign of relenting. So, higher inflation leads to higher needs and expectation of higher future interest rates.

If we were talking six months back, all major central banks’ first rate hike expectations were not until 2023. These expectations have now been dramatically brought forward and brought forward in good size, you know.

We are now looking at bigger rate hikes nearer, in the near future. I’ll come to the major central banks in a second, but rate hikes, an increase of 50 basis points have been coming from central banks all over the world. You name a central bank, say, they’ve all been hiking rates, Brazil, Mexico, in EM world Malaysia, Philippines, Poland, Czech, India, South Africa, the list is just endless.

In G-10 effects we have seen rate hikes from the US, UK, Canada, Australia. And finally, last week, like you mentioned, even the European Central Bank has communicated an end to their asset-purchase programme, with rate hikes coming in July and September. We need to keep in perspective that some of these hikes and expectations are coming almost after a decade. The markets had been used to benign and easy monetary policy for years now.

So these drastic changes in outlook, they’ll happen at a very sharp pace and, hence, all assets have been repriced accordingly. Add to that the geopolitical risk with Russia invading Ukraine and the global growth concerns, it’s a horrible mix for us, and a central banker’s nightmare scenario.

With risk uptones in the markets, the US Treasury bills and the dollar have been the go-to “safe-haven” asset. As we have all seen, the US dollar has appreciated sharply against all currencies. While the dollar index was around 94-95 earlier in the year, we are now at 104, so let’s say an appreciation of 10%. And sterling has depreciated from 1.36 to 1.23, almost 10% weaker. And even the euro, obviously, everything has gone down against the dollar, from 1.14 to 1.05, again nine-odd percent weaker from February.

So not just the majors, the EM currencies have borne the brunt as well. Chinese yuan, Indian rupee, everything weaker against the US dollar. Last few weeks the market did stabilise and we saw some range-bound price action, but with the yet higher inflation trend on Friday for US inflation we saw another bout of dollar strength and I think it’s going to continue that way for some time.

HP: OK, so as you look forward into the second half of this year and into 2023, what do you think the key risks are for FX markets going forward?

BG: We are getting into a very interesting landscape. The path ahead is littered with landmines, if I may say. I’ve already highlighted the inflation concerns which will remain the biggest driver of FX. A lot will also depend on a) the various central banks’ outlooks, ie their monetary policy path signal, what they signal, and what they do, the two are slightly different. And b) their credibility itself. The Fed hasn’t done itself any favours by calling inflation as transient for the whole of last year.

Now they are having to play catch-up and, you know, baby steps of 25 basis points are out of the window, 50 is the new 25. Before the inflation print last Friday, two Fed hikes of 50 basis points were priced in, but now we have three hikes of 50 basis points priced in, and, like you mentioned, some market participants are also calling for a 75 basis points.

So ECB has also been widely seen as falling behind the curve to the detriment of the euro. The Bank of England is actually the first major central bank to openly talk about stagflation and recession risk. So most importantly, going forward, the central bank policy will dictate our future course of action.

Other than that, we have a few more risks to watch out for, the known unknowns as we would call them. Firstly, the supply-chain issues, with China lockdowns, are a constant overhang on the economy. While China eased their two-month lockdowns in its major cities just on 1^st June, they had to reinstate some restrictions in some certain cities just in a matter of 10 days, so this zero-COVID approach from the Chinese government and these partial lockdowns could remain a disrupter in the immediate future.

Secondly, how the Russia/Ukraine situation pans out, that remains to be seen because it can have an impact on the gas and fuel prices and, hence, ultimately, on inflation. And, you know, I think it’s not really premature. Still, rightly, you know, we have stagflation and recession concerns coming in. The Bank of England has already warned of low growth and higher inflation in the UK. If these growth concerns were to become more widespread, then there can be more volatility and more choppy moves in currencies.

All in all, I think we need to realise that we are undergoing a big regime change right now. Decades-old monetary policy of low rates and central banks pumping in liquidity is coming to an end. This could have a, I would say, significant impact on all asset prices and obviously in the FX market it will lead to a lot of realignment.

In the immediate future, just this week, we have four major central banks lined up, all bunched together. We have the Fed on Wednesday followed by Bank of England, Swiss National Bank, and the Bank of Japan meetings. What they say, going forward, in terms of what core guidance we get from them, that will be important. The market is sitting on tenterhooks at this point of time.

HP: So when you look across FX markets, are there any outliers, any significant movers that our listeners should be aware of?

BG: The entire, all asset, all FX has gone through a big realignment, but, yes, while all major currencies have had a 9% to 10% move, the Japanese yen stands out a bit. It has depreciated from, where were we, about 115 early in the year, 234 today, so a depreciation of about 16%, 16% to 17%. This stands out. It’s one of the worst-performing currencies, but that has been exacerbated because of the divergent policy paths from both the US Fed and the Bank of Japan.

While the Fed has been aggressively hiking, the Bank of Japan is still keeping rates low and the carry trade is also coming back into the play, with one-year US dollar and the yen interest rate differentials at almost around 3.2%, so that is something worth watching. It could continue for some more time.

HP: So, how are investors taking advantage of the current market moves that we’ve been seeing and, of course, the levels that are now on the screen?

BG: A very interesting question, Henk. We have seen different investor segments trading slightly differently on this move. A lot of, you know, eurozone investors or UK- or Europe-, you know, based investors who have assets in foreign currencies, in US dollar let’s say, they are simply looking to lock in the gains on their foreign assets. A 10-odd percent appreciation in their foreign currency asset, just purely because of a currency gain, is difficult to let go of. It’s a low-hanging fruit not to be missed.

So these investors have been locking in the gains by just way of buying euro calls or sterling calls, they have been trading both options and forwards to lock in their gains, while on the other side, you know, some other investors, neutral investors I would say, the speculative money, they have been taking advantage of the choppy price action, so buying into dollar strength every time they see a dip in the dollar, and then just trading the range for some time with dollar strength in play.

Though that’s speculative that’s a slightly tough one, so one has to be careful, especially this week critically. It’s a very critical week this week, so one has to tread with caution there.

HP: OK. Let’s finish off. Let’s continue to look forward for the rest of this year. What are some of the key trends that you expect to emerge in the months ahead?

BG: We reckon the dollar will continue to strengthen. In terms of volatility, these choppy moves will continue. We will see the market changing direction just on probably headline news flow. So choppiness and volatility will stay high. All in all, we do expect the dollar to stay stronger throughout the year.

HP: Well, thank you, Bhaskar, for your insight today. We appreciate you sharing your thoughts on what is set to be an interesting period for currencies as markets react to heightened geopolitical uncertainty along with changing interest rate predictions and growth rate projections.

Moving on to the week ahead, and as we were just talking about, it’s certainly a huge week for central bankers, where the focus will start with the Federal Reserve meeting. With unemployment in the United States heading back towards pre-pandemic lows, sky-high inflation, no surprise that the US central bank have increased the intensity of policy normalisation. We now think it will be a close call between a 50 and 75 basis point hike at Wednesday’s meeting. We now see the terminal rate for Fed funds being higher, at 3% to 3.25%, in early 2023.

On Thursday we get the interest rate decision in Switzerland. We expect the Swiss National Bank to sound hawkish at the June meeting, to lay the ground for a 25 basis point hike in September. A risk of a 25 basis point hike at this meeting cannot be discounted, with a delay in the hike in September only increasing a chance of a 50 basis point initial move.

Normalisation should be supported by the upward revision of the inflation forecast coming through from the Swiss central bank, while its growth forecast is unlikely to be revised down significantly. We expect the resilient Swiss economy to support the SNB to hike 25 basis points per quarter for the next four quarters, to bring rates marginally above zero to 0.25% at the June meeting next year.

In terms of the UK, of course, we expect the Bank of England also to hike rates by 25 basis points at the Thursday meeting, the fifth consecutive increase. In terms of the outlook beyond that, we look for another 25 basis points in August, the MPC then pausing at 1.5% as the cost of living starts to impact growth prospects.

And with that, I’d like to thank you once again for joining us. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.