The Fed and the BOE a tale of two central banks

The Federal Reserve has unleashed a new wave in the dollar rally and treasury yields have surged after it announced that it plans to hike interest rates three times next year. The market reaction to this move has been whole-hearted, the dollar index is up nearly 200 points, and US Treasury yields are back at multi-year highs. The 10-year yield has increased by 20 basis points since Yellen’s press conference, bringing the total increase since Trump was elected President to 80 basis points. Even stock markets had a measured reaction, and current futures prices suggest that US indices will claw back some of yesterday’s losses at the open. So is this the sweet spot for the Fed? At some point Yellen will have to take the punch bowl away, but for now, that is a concern for another day.

Trump vs. Yellen

The market disregarded Yellen’s view that the shift in the ‘Dot Plot’ was small, and not all members actually agree that rates need to rise next year. However, Animal Spirits, unleashed by President-elect Trump, have won the day. The view seems to be that Trump will deliver on his fiscal stimulus promise, the economy will expand sharply, inflation will rise and the Fed will need to hike rates more than currently forecast, but not by enough to lead to a serious stock market sell-off. The market is fully embracing Trumpenomics, which is bad news for emerging markets with dollar-denominated debts, it also signals the beginning of the end of the low interest rate environment.

You can read our full Fed reaction here: https://www.cityindex.co.uk/news-and-analysis/fed-overview-when-2-became-3-and-a-side-of-trump/

Bank of England not Trigger Happy

At 1200 GMT the Bank of England is scheduled to announce its latest interest rate decision. It will also release the minutes of its last meeting of 2016. No change in policy is expected; instead the focus will be on the minutes.

We will be looking for any shift from the neutral policy stance that the Bank has held during Q4. Mark Carney summed up the Bank’s stance by telling a Parliamentary Committee in September that the Bank of England is not out of ammunition, but is not trigger-happy either.

Here is a short list of the things we are looking for in the markets:

• Inflation: price pressure is building, could the larger than forecast increase in prices in November worry the Bank, especially if this pace of increase continues?
• Any clarification on just how tolerant the Bank will be of an inflation over-shoot.
• Could the Bank balance any hawkish concern about inflation, with concern about the impact of Brexit and the triggering of Article 50.

However, if the BOE does sound concerned about the spectre of rising price pressures at this meeting, will the market even take it seriously? The memory of the Bank’s tolerance for high inflation whilst not raising interest rates back in 2009 – 2011, could lead to some scepticism about the prospect of policy action from the BOE in the years ahead.

The Fed overshadows the BOE

This meeting comes hot on the heels of the Fed meeting, which is undoubtedly more important for the markets. Thus, the impact on the pound could be mild, especially if the BOE does not materially changes its stance from November’s meeting.

What next for the pound?

Post the Fed meting; GBP/USD has been trolleyed by a rising dollar. It dropped back some 200 pips since yesterday, and the technical indicators have also turned bearish, GBP/USD is now back below the top of the daily Ichimoku Cloud, which signals the end of the pound’s rally.

We think that GBP/USD could struggle from here, due to the strength of US treasury yields, which is fuelling this dollar rally. Instead we look at EUR/GBP, which is close to crucial support at 0.8308 – the 200-day sma. A break below this level opens the way to 0.80. We also think that, on balance, the ECB will be more dovish than the BOE next year, which could lead to a further decline in the German – UK 10-year yield spread. This spread is already at -1.1%, but could fall back to pre-Brexit lows around -1.3% in the coming weeks, back then EUR/GBP was trading around 0.7600.