I feel like I have been shot out of a canon. So much has happened since the start of the year, it feels like we are already halfway through. It’s only February!
Yesterday we had 2 major central bank meetings; the Bank of England (BoE) and the European Central Bank (ECB).
The BoE increased interest rates by 0.25% as anticipated. However, what did surprise the market was that 4 MPC members had voted for a 0.5% increase in the base rate. One more voter and we would have had it. This was a hawkish surprise and risk assets reacted accordingly. Front end UK rates sold off and the Pound was higher.
Having listened to many central bank meetings over the years, this one struck me as negative in tone. Andrew Bailey, the BoE head, acknowledged that the inflation that was being experienced by the UK was mainly a supply side shock and there was little that monetary policy could do to stop it. However, the BoE needed to do something and so increased rates to try to suppress demand.
The BoE was stuck between a rock and a hard place; keep rates unchanged and allow inflation to keep running up (expectations are for it to peak at 7.25%) or hike and start to hurt demand. They chose the latter and acknowledged that they had to otherwise things would get worse.
Come April, UK consumers are going to start to feel a world of pain. Floating mortgage payments are going to reset higher. Energy prices are going to go up (though there is a fiscal push to reduce the impact on households) and national insurance contributions will increase. All the while, oil prices may continue to move even higher as supply side issues continue to dominate.
I don’t see how this ends well. Consumption in the UK is going to collapse in my view with inflation potentially remaining sticky. Hello stagflation!
The ECB also met. Earlier this week CPI printed at 5.1% in the Eurozone. Christine Lagarde indicated that they may well hike rates this year. This is after having rejected such action in previous meetings. This was an enormous volte-face which was not anticipated at all. There were huge moves in Euribor with the rate curve flattening and Euro rallied versus peers.
The ECB is also stuck in an enormous quandary. There is a need to reduce bond purchases and increase rates as inflation begins to increase and may even become sticky. However, doing so will inevitably result in the peripheral bond spreads increasing both in outright and relative terms to benchmark rates. This may then cause a mini (large?) crisis. Such an outcome is not something that the ECB has the ability to fix in this instance given the more fractious nature of politics within the zone. Bye bye Euro!
What have I learned? Over the past 3 months whenever central bank meetings approach, I have asked myself the same question: is there too much priced in or are we not hawkish enough? Always, the answer comes back as the former only for us to be surprised when banks are more hawkish. What this tells me is that market participants are conditioned to think that rates cannot really move up materially. At least in G10 space. That inflation is going to peak and begin to subside. I think the asymmetry is thinking that perhaps things have already gotten out of control and central banks are trying to get credibility back.
The second lesson is that when observing moves in FX, what matters in the near term is what a central bank does at the margin versus peers. The ECB made a bigger shift relative to expectations and pricing versus the UK yesterday. Even though both were hawkish, the ECB was more so, which results in EURGBP rallying aggressively. This is something to consider for shorter term momentum traders.
Ah yes! Japan. Now that all central banks have really started to talk more hawkishly, the BoJ really stands out. A question of perception versus reality has emerged. As everyone else is hawkish, people are starting to think about paying rates in Japan anticipating a change in tone there. Rates in Japan have already moved a decent way off the lows with 5yr bond yields trading above 0. This has not happened since 2016. I don’t know whether this notion is simply people having not caught the moves in Europe and other areas simply looking at what has not moved and trying to chase. Perhaps the reality will be very different. In either case, it does make a decent argument to be long Yen.
Given the backdrop I have mentioned, I will be spending time working on short UK and Europe risk trades. I do not see how the current environment and what is to come is a reason to own Sterling for example. Currently both the Euro and the Pound are benefitting from tightening policy versus peers. However, there will be an inflection point where the FX starts to reflect credit risk. The issue will be the timing of such a turn. The Yen is cheap on a REER basis (it has been for some time) and should trade well from here.
Quay Partners Group is a service-as-a-platform investment management solutions for independent hedge fund managers and family offices.
Supun Ekanayake is a Partner at Quay Partners Investments (UK) LLP and has over 15 years’ experience trading across all asset classes.
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4th February 2022