The week ahead: previewing the Fed and the first indication of July’s economic performance

It may feel like it’s peak holiday time, but this coming week will be crucial for financial markets. There have been some key data releases and earnings news that are starting to change the narrative about the outlook for the rest of the year, along with a series of improving data points for the UK that suggests our economy is not the basket case it looked like a few months ago. The Federal Reserve and the ECB are set to hike interest rates by 25 basis points each this week, but the key question for investors will be what they do next. Investors will also be watching to see if the Bank of Japan continues to keep interest rates on hold. In fairness, they have decades of experience of keeping interest rates at 0% or in negative territory, so this shouldn’t come as a surprise. Added to this, China’s 0% CPI rate could start to spread, and Japan is first in line if it does. Overall, this could be a pivotal week for stocks, and for the future direction of the dollar.

The UK’s improving outlook

Based on UK asset prices in recent weeks, financial markets need to stop relying on individual data releases to make their assessments about a country, currency, or other asset price. The inflation data for May spooked the bond market, sent the currency surging and UK mortgage rates rose to dangerous levels. The spread between the UK’s government bond yields and its peers rose, suggesting that the UK was an outlier, and its economy deserved a risk premium. However, a mere few weeks later, Inflation is finally coming down as we found out in June’s data. The annual rate of UK inflation dipped to 7.9% last month, and there is now good reason to believe that UK prices could fall to sub 7% for July. Transport costs deflated sharply in the June data, however, in July this is set to be accompanied by household service inflation, which is expected to fall sharply as changes to wholesale energy prices are finally reflected in household bills. For example, the decline in the energy price cap is expected to see household services inflation fall from 1.7% YoY to 0.4% YoY. Food costs are also falling and are expected to continue to track spot agricultural commodity prices lower in the coming months. Since food and non-alcoholic beverages make up nearly a quarter of the CPI basket, this is also an important development for the UK’s inflation outlook. Added to this, core CPI rose by just 0.1% last month, which could be a sign that demand is softening and that tightness in the labour market is abating.

Growth surprising on the upside

Not only is inflation falling in the UK, but retail sales surprised on the upside, rising by 0.7% MoM in June, following a rise of just 0.1% in May. The ONS have reported that there were increases in sales across all the main sectors except for motor fuel, which is also encouraging, and suggests that the UK economy returned to growth in June. While some may argue that rising retail sales could spark more inflation, this looks unlikely, since inflation in the retail sales data fell to a 17-month low at 0.2% MoM, and 6% YoY. Added to this, the government borrowed less than expected last month as strong tax revenues and a falling debt interest bill helped to boost the public finances. Public borrowing rose by £18.5bn last month, less than the £21.1bn forecast, borrowing was £400mn lower than the same month last year. The UK’s debt interest bill, while still huge at £12.5bn last month, is shrinking compared with a year ago. The bad news on the public finances was that public sector debt to GDP rose to 101%, which will add pressure to the Chancellor to get public sector debt levels back under control after the pandemic excess.

What the BOE does next

Overall, this data could give the BOE pause for thought at its next meeting at the start of August. Falling inflation and a decent economic backdrop is a much brighter forecast than what had been expected a few weeks ago. We expect the BOE will hike rates to 5.25% when it meets in early August, we think that we could be very close to the peak, and the prospect of 6%+ for Bank Rate in the UK is now off the cards. This will brighten the outlook for the UK economy, but it is negative for the pound.

Too early for the Fed to call time on rate hiking cycle

What comes next for the dollar will depend on the outcome of this week’s FOMC meeting. The Fed is expected to hike interest rates by 25bps, and the market is pricing in a near certainty of this happening. However, what happens in September and beyond is less clear. The market seems to be confident that the Fed can deliver a soft landing, while maintaining interest rates around the 5.25% for the rest of this year. Although headline inflation in the US fell back to 3% last month, core inflation is still too high, the Fed’s preferred measure of inflation, the core PCE rate, was 4.6% in May. Thus, will the Fed focus on the fact that there is more work to be done on inflation? We believe that it could be too early for the Fed to say that they have won the war on price growth, and that western central banks will err on the side of caution when it comes to the future path of monetary policy out of a desire to avoid another surge in inflationary pressure. Overall, we expect Jerome Powell to remain committed to data-dependency, which, as we’ve seen in the UK, can increase market volatility.

Earnings galore

This makes the premilitary PMI reports for the Eurozone, the UK, and the US important data points to watch next week, to see what signal they give about inflationary pressure in the west, and to see if activity is holding up as we move through the summer months.

We would also like to note that Thursday was the second worst daily performance for the Nasdaq so far this year. Tesla was one of the worst performers on Thursday, along with Netflix, after both announced worse than expected earnings. Both stocks suffered further declines on Friday, suggesting that companies who fail to deliver this earnings season will be punished by the market. Sentiment remains fragile this earnings season, as analysts expect another quarterly decline for earnings in the S&P 500. This week will see a huge number of companies report their results for Q2, including Apple, Alphabet, Microsoft, Coca Cola, US mid-tier banks, UK blue chip banks, Boeing, and other US airlines. Thus, there’s unlikely to be a dull moment for financial markets this week.