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Feet on edge of diving board ready to jump into the pool

Taking the plunge

Demitri Theodosiou

Demitri Theodosiou | Head of FX and Interest Rates Trading

As inflation peaks, how are central banks considering their options? Read Head of FX and Interest Rates Trading Demitri Theodosiou’s latest “Thoughts of an FX Trader”.

 

I was sitting at my youngest boy’s swimming lesson at the weekend thinking about a theme for this article. There were a lot of events coming up in the next month - Valentine’s day, Pancake Day, the Super Bowl, the Oscars – in fact if anything I was spoilt for choice making it hard to decide. We have lots of nice analogies possible from that list relating to markets, from flipping pancakes for central banks possibly flipping from rate hikes to cuts, to awards for most volatile currency or aggressive central bank action. While I sat feeling indecisive, Matthias caught my attention. He doesn’t like swimming - he has lessons with a lady called Sarah who patiently guides him in the lesson while he spends the whole time negotiating with her that if he does one thing he doesn’t have to do another. Sarah was trying to coax Matthias into jumping from the side into the pool, body and legs straight like a pencil. Matthias was trying to persuade Sarah that if he did that she should catch him. He stood on the edge of the pool, toes dangling over the side, trying to muster the courage to take the plunge.

Indecision has been a theme for central banks in the wake of the Covid-19 pandemic.

Indecision has been a theme for central banks in the wake of the Covid-19 pandemic. Firstly on whether to raise interest rates in the face of inflation they deemed to be transitory, then on how fast and far to hike interest rates to stifle inflation that proved persistent, without doing deep damage to economic growth, and now on when to finish the rate hike cycle and what to do next. Consensus amongst market watchers is that most major central banks are near their peak in interest rates as we have seen both the inputs to and actual inflation numbers subsiding in recent months. The timing and magnitude of interest rate moves has been the dominant factor driving FX, particularly across the pond with the FOMC leading the way with an aggressive hiking cycle and signalling a pause at the top while they wait for inflation to reach levels aligned to their medium-term price targets. This saw the dollar strengthen materially to record highs against many currencies, but just like financial markets priced in rate increases when the FOMC were insisting they wouldn’t, financial markets are now pricing in interest rate cuts for later this year instead of the aforementioned long pause being flagged. The market’s response to that has seen the USD reverse half of those gains in the space of just four months, despite similar expectations now being priced in for other central banks.

There are some nuances across major central banks that are worth noting, which could impact the timing of changes once we reach an expected peak of interest rates in the coming months. The USA saw inflation peak in June last year but continues to see a very strong labour market that could stoke more entrenched inflation and worry the FOMC, impacting their ability to pause or ease policy. The UK saw an inflation peak in October, and while narrowly missing a technical recession last quarter, continues to see a worrying trend of economic weakness. With the IMF forecasting the UK to be the only G7 economy to have a fall in GDP in the coming year, this outcome could weigh on the pound and cause real indecision for the Bank of England. An underperforming economy could see the Bank of England be the first to conclude raising interest rates and potentially begin easing, just as they were the first to raise interest rates back in December 2021. The Eurozone also saw a similar inflation peak in October, despite beginning their interest rate increases after the UK, but seem to be weathering the economic storm better than the UK after a milder winter than expected alleviated fears of reliance on Russian energy in the bloc that could have caused further inflation woes.

All three central banks will know the longer they keep interest rates high, the more they can dampen demand and ensure inflation comes back under control. They also know the longer interest rates stay high, the more potential economic damage they could cause and risk deep recessions, which could see below-target inflation in the medium-term. The timing of any peak in interest rates, and the beginning of any rate reductions will likely be the dominant force on currency markets later this year. Central banks will be standing on the edge of the pool with their toes dangling over the side, deciding whether to hold interest rates and take the risk of further economic slowdown, or take the plunge and start to ease policy.

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