EM Market Report

Inflation to break deadlock?

Thanim Islam
Thanim Islam 12 January 2023

- Who is right - the Fed or the markets?

- GBPEUR hits September lows

- Bank of Japan gives more signals that rate hikes are coming?

Yesterday

  • Markets remained pretty rangebound and subdued in the absence of any economic data, as well as the fact that markets are not willing to invest any fresh 2023 capital ahead of today's inflation print from the US.
  • ECB members Villeroy, Hozmann, and Rehn continued to beat the drum that the ECB will need to keep raising rates as core inflation has not peaked. The EUR had another go at making new highs versus the USD, and GBPEUR hit the lowest level since September 2022.
  • Fed member Susan Collins seems to be the dove amongst the hawks by suggesting that she is leaning towards a 0.25% rate hike in February.
  • JPY gained overnight on reports that the Bank of Japan will review side effects of its recent policy changes, suggesting that perhaps the Bank of Japan is to join the rest of the world in hiking interest rates.

Today

Market rates

* Daily move - against G10 rates at 17:00pm, 11.01.23

** Indicative rates - interbank rates at 17:00pm, 11.01.23

Table (4)-1

Data points

Table (5)-1

Speeches

  • USD – Fed members Harker and Bullard

Our thoughts

So all eyes on today's US inflation print, and what this means for the Fed's monetary policy. Currently markets are pricing an additional 0.50% worth of rate hikes over the first half of this year, and then 0.5% worth of rate cuts in the second half of this year. As we know, most of the strength of the USD over the last year has been down to the Fed's aggressive rate hiking cycle due to record levels of inflation. Signs of easing in the core inflation number will naturally bring down rate hike expectations, and thus weaken the USD.

However, should we see core inflation come in higher, we would expect the USD to gain back, and thus see GBPUSD and EURUSD back at the lows seen prior to last week's job numbers. Stocks will likely sell off, with the China risk-on trade taking a backseat to the fundamental dynamic.

Chart of the day

So, the impact of rising inflation on interest rates and thus the US dollar can be seen below - the core inflation is used to strip out volatile energy and food prices. Whilst the US job market, a key barometer for Fed monetary policy, remains strong with the unemployment rate at the lowest since February 2020, we can see average hourly earnings have dropped. That, combined with rising interest rates, could be said to have dampened core inflation in the US.

We saw a lower wage print in December, so now the question is will core inflation follow suit? If so, then expect markets to ante up their bets on rate cuts by the Fed later this year, and thus USD to weaken, despite the Fed continuing to protest that they will raise rates above 5% and keep them there all year.

So, regarding Fed policy and USD, the question now is: Do you believe the market, or the Fed?

12012023 cotdSource: Bloomberg Finance L.P.

Have a great day.