Inflation worries send bond yields higher, dollar lower
Inflation fears were further stoked by a massive upward surprise in quarterly inflation out of New Zealand last week.
Sovereign bonds worldwide continue to sell-off, but as yet risk sentiment and, in particular, stock prices are proving resilient, as investors bet that corporations are well-placed to pass costs along and benefit from extremely stimulative monetary policy. The dollar’s relationship with rising inflation expectations remains uneasy, and the greenback fell against every other G10 currency except the Canadian dollar. The Chinese yuan deserves a special mention, as it continues to ignore real estate troubles in China and rises relentlessly against all of its major peers. We expect the key event for currency markets this week to be the ECB October meeting on Thursday. Market expectations have been guided downward by recent dovish communications. Any hint that a hawkish faction is developing in the Council could be supportive for the euro. Also key will be the Eurozone preliminary inflation number for October out on Friday, and US third quarter growth and inflation numbers, on Thursday and Friday respectively.
GBP Bank of England Governor Bailey and Chief Economist Pill suggested last week that a hike in interest rates may be on the cards as early as the next meeting of the MPC in early-November. Futures markets have reacted aggressively, and are now fully pricing in the first pandemi era rate hike at next Thursday’s MPC meeting. We expect to see a 15 basis point move in rates, with another 25 basis point hike now looking likely to follow in February. Strong increases in house prices and overall inflation continued in October and September respectively, while the PMIs also surprised pleasantly to the upside last week, despite ongoing supply shortages. All in all, the rather muted reaction to the positive news in sterling is a bit puzzling, albeit the UK currency continues to trade just shy of its strongest position since mid-September versus the dollar. This week, all eyes should be on the release of the UK government’s budget on Wednesday. We will be paying close attention to the impact of sooner-than-expected interest rate hikes on the government’s updated growth forecasts.
EUR In contrast to the US and the UK, the Eurozone PMIs slipped, although they remain at high levels consistent with continued strong growth. The key event for this week is, of course, the European Central Bank’s October meeting on Thursday. Once again, no change in policy is expected, and the focus will be on communications from the council, with markets expecting a very dovish ECB. However, it’s worth noting that the gap between the ECB’s September projections for future inflation and reality has only widened. Another increase is expected when the October preliminary data is released the day after the ECB meeting. Given market expectations, even a neutral tone from President Lagarde would probably result in a sharp euro rally.
USD While higher Treasury rates have usually been a positive for the US dollar, on this occasion this backup is being entirely driven by rising inflation expectations rather than hope for better real returns. Chair Powell last week all but confirmed that the taper will begin in November, but this provided little help to the greenback, which dropped against most of its G10 peers. This week’s combination of third-quarter growth and inflation data should provide clarity on the stagflation issue; we are of the view that the current environment is clearly inflationary, but also relatively growth friendly, and expect positive surprises on both fronts. We still see plenty of room for market’s projections of Fed hikes to be brought further forward in time, in spite of recent moves in that direction.