Parky's quick take: 25 July

Fed and European Central Bank to hike 25 basis points this week, but is it the last?

After last week’s excitement over some of the UK data (inflation and retail sales), this week the focus is expected to be on the Federal Reserve and European Central Bank (ECB) meetings. 

The figures from the Euroland economy suggest that activity is weakening, and that with an economy already in recession (Q4 and Q1 saw output fall). The provisional Q2 Gross Domestic Product (GDP) figures might record very modest growth, but overall the economy is flatlining at best. As for the US, the signs of weakness in the housing market have been evident for a long time now, and although consumer confidence has been recovering, it remains at historically weak levels. Moreover, businesses are struggling more with the rise in the cost of finance. There are some signals of a weakening in the jobs market as well. While both the Federal Reserve and the ECB are expected to hike interest rates by 25 basis points, both central banks are also likely to signal that the tightening cycle is close to, or at, an end. 

One question is whether the US and Euroland authorities bringing to a conclusion one of the largest monetary tightening periods in the last 30 years, will prompt a change in the fortunes of the FX markets?

Slowing inflation to offer an end to the monetary tightening and USD weakness?

The drop in headline inflation rates (consumer), have been more than matched by falls in producer price inflation and also the slowing or outright decline in money supply across the major economies. 

There is increasing evidence that food prices are starting to reduce along with the sharp drop in energy prices. This should help bring down services inflation, with goods inflation expected to come down further and faster. However, if inflation and interest rates stop being as critical in terms of FX valuations, then what might? 

I think that there will be a return to relative growth differentials, and here the US is a distance ahead. Even with lower interest rates (the US is expected to cut earlier and deeper), the potential for higher returns on investment through growth could offer the USD some much needed renewed support. Will this week see a bit more USD improvement? Given the risks to the limited UK data and survey calendar and Euroland data and survey releases, I think so.

Other central banks coming to the end of the cycle, or not even starting it?  

This week sees the central banks of Indonesia, Japan, and Chile decide on monetary policy also. Bank Indonesia is expected to leave interest rates on hold, while the Bank of Japan is also expected to leave policy unchanged, but it might make some adjustments to its forecasts for inflation and growth. 

The Chilean central bank meeting could be the most interesting of all three. With domestic inflation concerns easing and a stable currency, the options for a 50 or 75 basis-point cut are there. Markets are pricing for a 75 basis-point cut, but the central bank might be marginally more cautious at the start. Whatever it chooses to do, the signal from a number of emerging market central banks appears to be that the risk of another surge in inflation is fading, and there are larger downside risks to the economy now.