Potential volatility ahead with new-look US monetary policy

The Federal Reserve’s guidance-lite meeting puzzled financial markets

The Fed’s new Chairman, Kevin Warsh, had triggered dollar-buying at his first meeting in June. He quashed fears that the Fed would succumb to Trump’s demands for interest rate cuts, and made clear that he was serious about combating inflation. In July however, the distinct lack of guidance – set to be a feature of Warsh’s reign – left investors with more questions than answers. The dollar weakened not only on the decision not to raise interest rates, but further on the uncertainty surrounding policy going forward. The pros and cons of forward guidance as a monetary policy tool are up for debate, but without it markets have fewer clues to inform decisions. A likely consequence of the Fed’s new approach is greater volatility in short-term interest rate markets, and currency markets too.

Joint US-Japan intervention saw a sharp yen rally

USDJPY rose to a new post-1986 high in July, as the Japanese currency continued its steady weakening. The yen’s decline is adding to upward pressure on domestic inflation, and Japanese authorities stepped in again to stem the weakness. The difference this time is that the US waded in too, selling euros and buying yen. There are questions as to why, but the current thinking is twofold. First, the weakening of the yen and Japanese government bonds coincides with general bond market weakness, and therefore a higher cost of borrowing for the US Treasury. Second, if intervention were left to Japan alone, the authorities would likely be selling some of its $1.1trn holdings of US Treasuries to fund the USD needed to strengthen the JPY – again, raising US Treasury borrowing costs. This could be a turning point for the yen landscape, and wider FX markets.

Notes: dma = day moving average
Sources: Macrobond, Bloomberg, Investec

Sterling awaits clarity on the direction of UK policy

Andy Burnham has been appointed Prime Minister, and his Cabinet has been assembled with John Healey taking the reins as Chancellor. Devolution is a clear priority for the government, but the broader fiscal policy landscape and the health of the public finances is the key focus for gilt markets and sterling. The government’s first Budget is set for Wednesday 28 October. Burnham has pledged to stand by the Labour manifesto to not raise taxes on working people, and to get “really serious” about cutting the welfare bill. However, the new PM also commented that the government will use any flexibility within the current fiscal rules, which triggered a bout of nervousness in sterling and UK assets. The fiscal trajectory has a big part to play for sterling in the coming months, after the pound finally broke through 1.1600 versus the euro to reach a one-year high.

The euro’s attention will soon turn to politics too

The Eurozone saw better-than-expected growth in Q2, and should continue to get a tailwind from the increased investment and defence spending, particularly in Germany. However, our economists suspect upcoming elections in France and potentially Italy could spell trouble for the euro. A second ECB interest rate increase could provide a lift in the short-term, were that to go ahead in September, but the looming political risks are a worry. Marine Le Pen has been cleared to stand in France’s presidential election next April. Were she to win, European politics could become increasingly fractious. Still, that is some months away. For now, the key focuses for the common currency are the Middle East and the subsequent impacts on inflation expectations and interest rates. EURUSD recovered to the 1.1500s on the USD’s recent weakness – our economists expect a short-term rally from here on uncertainty ahead of the US midterm elections.

Sources: Macrobond, Bloomberg, Investec
Chart data as of: 13:41 BST, Wednesday 5 August

Forecasts

Sources: Investec, Macrobond, Bloomberg

Sources: Macrobond, Bloomberg, Investec

Sources: Macrobond, Bloomberg, Investec

Notes: Forecasts are produced by Investec Economics and are for end-quarter
Chart data as of: 13:41 BST, Wednesday 5 August