A triumvirate of central banks, and the NFP thrown in for good measure

It’s a huge week for the global economy, and after some large moves for financial markets at the end of last week, it appears we are at a crossroads: will US stock indices continue to break into fresh, record-breaking territory, will the pound decline to a fresh 2019 low and will central banks start to ease in unison? 

The low down on the Fed

Financial markets have been convinced for some time that the Federal Reserve will cut interest rates when it meets this week, the bigger question is how far will it go? Will it opt to cut by 25 basis points or 50 basis points, and will this be the start of a rate-cutting cycle? The CME’s Fedwatch tool has calculated the odds of a 25 bp cut at 78.6%, with the odds of a 50 bp cut (usually restricted to crisis periods) at 21.4%. A month ago, the odds of a 50 bp cut were even higher at 32.3%, so the market has become less dovish in recent weeks. A strong NFP reading for June, combined with better than expected Q2 GDP have shaved expectations for a larger rate cut at this meeting, however price action has been difficult to figure out. As the market has become convinced that the Fed will cut interest rates, US stock indices have reached record highs, however, the prospect of lower interest rates has not weighed on the dollar, which reached a 2-month high on a broad-basis at the end of last week. 

The market reaction to the Fed 

So, who will win out? Is the FX market considering that the Fed’s rate-cutting cycle will be short-lived, the US will continue to have an interest rate advantage over other developed markets and the dollar rally can continue? Or is the stock market correct? The S&P 500 isn’t rallying on the back of a plethora of strong Q2 earnings reports, which have been mediocre at best, instead it seems to be rallying on the prospect of looser monetary policy from the Federal Reserve. 

Why Powell may stick to his dovish script 

It’s always risky to speculate what the Federal Reserve will do, especially as we have absolutely no insider info from the Federal Reserve, but what we do have is experience of hundreds of past Fed meetings, which is why you may find our speculation for what may happen on Wednesday evening useful. We believe that the Fed will only cut by 25 basis points, they can’t justify a 50 bp move at this stage after strong job growth and a decent Q2 GDP reading. This will initially disappoint the market; stocks could fall along with the dollar. However, the Fed chair may use his press conference to keep the door open to further rate cuts down the line, and his overall message could be more dovish than some expect. The Fed chair’s testimony to Congress a few weeks ago leads us to believe that he will be happy to let the economy “run hot” for a little while by embarking on a short-ish rate-cutting cycle. In that testimony he stressed how job growth was helping the very poorest in society, which is going someway to address the income disparity in the US that has arisen in recent decades. This is a noble cause, and one we doubt that the Fed chair will want to disrupt by tightening the screws on the US economy too soon. Yes, we know the politics are messy, and the Fed will want to assert its independence from President Trump who keeps berating the US central bank for not cutting rates fast enough, however, we expect Fed chair Powell to stick to his guns this Wednesday and maintain a dovish tilt to his message. 

Due to this, we expect any decline in US stocks to be short-lived, with growth-focussed stocks like consumer stocks and tech stocks to perform particularly well in the aftermath of the meeting. The dollar may face a longer period of decline, however, with the ECB set on expanding its stimulus programme later this year, and the Bank of England set to focus on the risks to the UK economic outlook when it releases its Inflation Report later this week (see below for more), the dollar may claw back its losses fairly quickly. 

US data deluge, and why the NFP report is getting more erratic 

There is the usual start of the month data this week, with PMI reports and US ISM’s to watch. Overall, Europe is slowing, the US continues to surprise on the upside, and this is reflected in the stronger position of the dollar especially vs. the EUR and GBP. US job growth is expected to be 170k for July, which is lower than the 224k reported for June. Considering the May report was in double figures, there hasn’t been a prevailing trend for NFPs for some months. Thus, this month’s NFP figure is anyone’s guess. The NFP report remains one of the world’s most important monthly data releases, however, volatile summer time trading conditions could mean that the market reaction to this Friday’s report is even more amplified than normal. Thus, if we get a significantly stronger or weaker reading, we could see an immediate large move in the dollar and stock markets. We would advise caution if you are trading around the NFP release this Friday. 

UK: the doves take control at the Bank of England 

The Fed isn’t the only central bank in town this week. The BOJ announces its policy decision on Tuesday, we expect it to remain steady, but continue to threaten looser policy if the yen continues to strengthen. The Bank of England’s Inflation Report is also due on Thursday. We don’t expect any policy change at this week’s meeting; however, we expect a decent GDP downgrade for this year, which is likely to be a lot worse if we leave the EU without a deal in October. We also expect the Governor Mark Carney to boost his dovish rhetoric, especially as the latest economic data is expected to suggest more downside for the UK economy, with the manufacturing sector falling further into contraction territory in July, and the construction sector remaining weak. Hawkish sentiments from some BOE members including Saunders and Haldane are likely to be tempered after the recent spate of weak economic data. However, the BOE is in a bind, although growth is likely to be revised down for this year and potentially for next, inflation in the UK is running above that of other developed markets, and the recent decline in the pound is likely to weigh on prices even more. Thus, we expect the BOE to fall short of signalling a rate cutting cycle in the near term, instead preferring to wait and see how Brexit happens in October, and then reacting to the economic fall-out in real time. 

A glimmer of hope for a pound recovery 

The pound had a torrid performance at the end of last week, falling 1% vs. the USD, and it kicks off this week trading around $1.2380. GBP/USD is at a cross roads as we lead up to this important week for financial markets. The technical signals suggest that the pound is stretched to the downside, and there is a major support zone at $1.2350, which could limit further GBP/USD downside. However, the path of least resistance for GBP remains lower and each time that we have held out hope for a GBP/USD recovery it has fallen at the first hurdle. In this environment, the prevailing trend for a currency pair must be respected. However, could a dovish Fed be enough to allow GBP/USD to recover to the relative safety of $1.25? A deeper decline below $1.2350 does not seem feasible to us at this stage, firstly, other central banks are likely to strike more dovish tones than the BOE this week, secondly, the politicians are all on holiday, Boris looks like he could win a general election and the new Tory cabinet are at least making plans for a no-deal Brexit to, in theory, limit too much of a chaotic exit from the EU. Thus, yet again we hold out hope for a mini recovery in GBP/USD towards the end of this coming week, when a move back above $1.25 looks feasible from political, economic and technical stand points.