ECB is no FED

Nordea with a worthwhile piece. Remember, where the EUR goes, AUD follows.

Risk sentiment remained fragile this week, with equities declining and credit spreads widening. In the Euro area, the risk of a 50bp rate hike has increased, but we are not convinced it will materialise. In the FX space, the GBP remains vulnerable.

“Based on current knowledge, my preference would be to raise our policy rate by a quarter of a percentage point. Unless new incoming data in the next few months suggests that inflation is broadening further or accumulating. If that’s the case, a bigger increase must not be excluded either.” – Klaas Knot, President of the Dutch Central Bank

Equity prices continued to decline this week and on Wednesday the S&P 500 suffered its worst decline since June 2020. Usually central banks (especially the Fed) could soften their stance and offer some support for the markets, but currently inflation is enemy number one, indicating that there is no room for dovishness. On top of that the growth outlook is increasingly uncertain. Against this backdrop, equity markets remain vulnerable.

Chart 1. S&P 500 heading for its seventh weekly decline


This week, ECB’s Knot, a well-known hawk, suggested that the ECB could hike by 50bp in July if inflation surprises to the upside in the coming months. The comment pushed interest rates and the euro higher on Tuesday – currently the market is expecting more than 110bp worth of hikes from the ECB by the end of the year. The market pricing is rather aggressive, and we currently expect the ECB to hike three times this year, although we do note that risks are tilted towards more hikes.

Still, the ECB is not the Fed and if there is a need for a faster policy tightening, it’s more likely that the ECB will hike by 25bp four times this year than starting with a 50bp hike. It’s also worth noting that Knot’s comments are conditional, data needs to surprise to the upside. That is not the case in the US, where the baseline is that the Fed will hike by 50bp in June and July.

All in all, a 50bp rate hike from the ECB at the July meeting looks unlikely for several reasons as we argue herebut in the current environment, one should not exclude even scenarios that appear unlikely at the moment.

Sterling is in a tricky position

In the FX world, Banque de France’s Governor Villeroy’s comments indicated that he is worried that the euro’s weakness will drive imported inflation even higher. Although the EURUSD has moved lower and will likely continue to do so, we do not think that the ECB is too worried about the euro’s weakness – on trade weighted terms, the euro is still strong.

On the other side of the Channel, the British pound is stuck between a rock and a hard place. On the one hand inflation rose to 9% in April, but on the other hand consumer confidence dropped to a record low in May and the projections from the Bank of England show that the economy will end up in recession if the central bank hikes aggressively, which is not a good scenario for the GBP. However, if the central bank hikes less than the market expects, the yield difference between the UK and the Euro area should narrow, which usually indicates upward pressure for the EURGBP.

Chart 2. Tables have turned; yield differential is not supporting the GBP anymore


As equity markets continued to slide, Scandi currencies have been unable to appreciate. The Riksbank’s monetary policy tightening offers some support for the SEK and our base case is that the EURSEK will move towards 10.40 if and when the market sentiment improves, but the housing market is a potential negative driver for the SEK. The Riksbank’s rate hikes and rising interest rates combined with the high supply of homes indicate that the housing market will struggle going forward. We expect home prices to fall by 10% by the end of 2023 and the risk is that the markets start to worry that home prices will drop even more, which could increase risk premium in the SEK.

Chart 3. We expect Swedish home prices to decline


The NOK weakening continued this week and EURNOK moved from 10.17 to 10.26. Declining asset prices together with lower or unchanged oil prices is a bad combination for the Norwegian krone. After the recent depreciation of the NOK, EURNOK is almost overbought, which usually indicates that the currency pair should head somewhat lower at least temporarily. However, if the risk-off sentiment continues, the NOK will have a hard time to strengthen materially.

Chart 4. EURNOK is at overbought territory


What is most important in the week ahead

This week’s main focus will be on new sentiment figures from the manufacturing and service industry in the Euro Area and the US (Tuesday). In addition, we will pay close attention to capital spending in the US (Wednesday), Personal Consumption Expenditure data (Friday) and Pending Home Sales (Thursday). Besides that, the main events of the week include the May FOMC meeting minutes release (Wednesday) and the interest rate meeting from the Reserve Bank of New Zealand (Wednesday).

The May FOMC meeting minutes are likely to display a hawkish Fed, whose primary goal is to bring inflation back down to its 2% target range, and that it will do so by hiking interest rates in an expeditiously manner. In addition, the minutes will reflect the Fed’s quantitative tightening propositions presented at the meeting: Reducing its balance sheet of US Treasuries and mortgage-backed securities by USD 95bn per month using a three-month ramp-up period of USD 47.5bn beginning in June.

There have been several hawkish remarks from committee officials since the May meeting and in this regard it is unlikely that the meeting minutes will bring any new hawkish signals. Surprises could include signs on the policy path. Put in plain English, investors are looking for signs that could indicate the Fed’s “threshold” for decelerating interest rate hikes from 50bp to 25bp. Nonetheless, considering officials’ policy stance up until the May meeting, we do not expect more nor less than a discussion showcasing a committee leaning towards interest rate hikes of 50bp at the coming meetings.

Judging from the May FOMC press conference by Powell and recent Fed speak we suspect the Fed will hike interest rates by 50bp at the coming two meetings in June and July, while assessing the inflation outlook before deciding how it will proceed. Looking ahead, we tend to see upside risks to even more 50bp hikes as service inflation is driving up monthly core inflation and goods inflation is yet to deflate. We do not expect services to slow down anytime soon, which does skew risks to more 50bp interest rate hikes as the Fed referencing Powell’s interview with the WSJ will “keep pushing” until we see “inflation coming down in a clear and convincing way”.

Chart 5. Rising services inflation


In the Euro Area the headline PMI composite rose in April as services managed to surpass the fall in the manufacturing industry. Looking ahead, we expect rising prices, monetary tightening, and dwindling household savings to take its toll on both the manufacturing and the service industry. The service sector, however, is likely to stay robust in the coming months, while the cyclical manufacturing industry is set for a large slowdown as tightening of financial conditions and reopening of the economy will skew consumption back towards services and away from goods.

Chart 6. Leading economic indicators in the EA are pointing to a slowdown


We will also start to watch the US housing market closely. Housing prices have increased by 35% since the start of the pandemic, which through a wealth increase effect has lifted household sentiment high. Recent housing data however is flashing more signals as higher borrowing costs bite. This year the average US 30-year fixed-rate mortgage rate has risen to 5.1% from 3.2% and recently housing market data is starting to fall. Mortgage applications are starting to roll over from high levels and this points to a sharp deterioration of home sales.

Chart 7. Home sales to drop as buyer dry up


Lastly, we will also pay a close attention to the Reserve Bank of New Zealand which is likely to continue hiking interest rates by 50bp at the next meetings to make up for lost ground and get on top of surging inflation.

Houses and Holes

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