Drawing with felt tips

The human polygraph test

Demitri Theodosiou

Demitri Theodosiou | Head of FX and Interest Rates Trading

In this month’s Thoughts of an FX Trader, our Head of FX and Interest Rates Trading Demitri Theodosiou attempts to decipher recent messages from major central banks.

 

Being a parent of two young boys can often feel like being a referee. Actually, to be more accurate, it can be more like being a human polygraph test. This weekend, after hearing a howl of pain from the upstairs, I raced to the boys to find them both rolling around on the floor with red tear-stained faces and fingers pointing firmly at each other. While they were both busy arguing they were innocent and the other “started it” my eyes fell to the felt tip pens without lids on the floor and the unmistakeable drawing marks on the carpet. There was quite a drastic tone change to the conversation as my interrogation began and the boys quite quickly forgot what their argument had been about, moving to defensive mode as they both vehemently denied involvement. Perhaps it was a ghost thought my youngest. That ghost has done a few mischievous things over the last year I replied. Without being there at the time it was hard to get to the truth of the matter, hard to know who was being honest and who was putting on a show to convince me. In the end, consequences were felt equally by both – perhaps the most just outcome I expect.

Deciphering the true intentions of the messages we heard from the three major central banks’ monetary policy meetings this month was equally as challenging. All three signalled we are at or near the expected top of the current interest rate hiking cycle, but all three messages were delivered in a very different way. Earlier this month in the Eurozone, the ECB performed a "dovish 25bp hike" as they increased interest rates but signalled this may be all that is needed. Last week across the pond, the FOMC announced a "hawkish hold" choosing not to change interest rates but signalled they may need to raise them a little further and due to the unexpected resilience of the US economy, rates could stay higher for a little longer. In the UK, the Bank of England unexpectedly held interest rates, with some improvement on the level of service price inflation and weaker surveys along with a recent soft GDP print helping pave the way for the pause. While all three central banks kept the door open to more "data dependent" interest rate rises, the contrasting tones and deliveries have led to a few interesting market moves.

Firstly, we have seen a strong US Dollar as the standout move in FX markets. This is unsurprising with the Fed the only central bank of the three to signal another hike likely this calendar year, adding a large upward revision to their Q4 GDP growth forecast rising from 1.0% to 2.1% (yoy) and keeping their inflation forecasts largely unchanged – a real "Goldilocks" soft landing if that plays out. This contrasts with the messages this side of the Atlantic from the ECB and BoE, and has been a driving force in currency markets in the last few days. We’ve also seen the Pound underperform against the Euro, with the Bank of England’s surprise hold seeing some repricing along the forward curve, and sending the Pound to levels last seen back in May against the single currency.

An argument that a stronger than expected US economy can handle further rate increases doesn't necessarily mean they are needed, with it being well known that interest rate changes have a significant lag before impacting the economy.

Secondly, in FX markets, FX Forward points saw a significant move. FX Forward points are the adjustment applied to a standard T+2 FX Spot contract when settlement is longer-dated, adjusting for the interest rate differentials (and demand) of both currencies. This adjustment accounts for the value of money over time and last week the entire Forward curve for GBPUSD made a significant move from negative to positive. This move signifies an expectation that US rates will now be relatively higher and for longer compared to the UK.

The sceptic in me can't help wonder how much of the hawkish tone of the FOMC and their ‘dot plot’ of future rate expectations is to be believed with interest rates already in such a restrictive place. An argument that a stronger than expected US economy can handle further rate increases doesn't necessarily mean they are needed, with it being well known that interest rate changes have a significant lag before impacting the economy. This implies that while inflation is currently above target, many of the recent rate rises are still to be felt in major economies and could get us to the right place in the medium term. Almost two years ago the FOMC called inflation ‘transitory’ before having to play catch up and raise interest rates at an unprecedented speed last year to correct. After what turned out to be an error of judgement, perhaps they believe it is better to remain firm in tone even at the risk of being overly hawkish and restricting their economy too much?

As more recent monetary policy tightening floods into their economy, will the Fed join their European counterparts and move to a more neutral stance?

US inflation has fallen faster and further than in the UK and Eurozone, helped by their more self-sufficient food and energy supplies, yet they remain the most hawkish in tone. US bankruptcy filings, both business and personal, are steadily increasing year-on-year, reflecting the pressure on households and businesses from over a year of interest rate increases that have raised the cost of borrowing significantly. As more recent monetary policy tightening floods into their economy, will the Fed join their European counterparts and move to a more neutral stance? More importantly, do they already think this and are using their hawkish rhetoric to position markets without having to follow through with additional action? As always time will tell, but much like with my children, at times with central bankers it can be hard to get to the bottom of who is putting on a show to convince us.


Disclaimer: All information is sourced from Bloomberg

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