US rates took a breather in their march higher, with the 10 year yield down 2 basis points. The ostensible catalyst for the sell off in risk assets was geopolitical concerns around the Ukraine crisis, which leaves most major emerging economies relatively unaffected (Russia excepted of course), US yields flat to lower and commodity prices higher. All in all a positive combination for emerging markets. The net result was a very unusual currency scoreboard, with Latin American currencies on top together with the G10 safe-havens, the Swiss franc and the Japanese yen.
The sterling rally paused last week on soft economic news out of the UK, namely the sharp decline in December retail sales, and a generally risk averse trading environment. However, the big upwards surprise in December inflation all but guarantees a Bank of England hike at its February meeting. UK headline inflation rose to 5.4% last month (above the 5.1% consensus), and its highest level since March 1992.
We are witnessing the development of a significant split in the outlook of the ECB governing council. By all accounts, it is growing less comfortable with its optimistic assumptions regarding a prompt return to 2% inflation, and there are disagreements over the wind up of the QE programme, as evident in the latest set of accounts from the bank’s December meeting.
The march upward of market expectations of Fed hikes continued last week, even amid risk aversion and lower yields in the US Treasury curve. Aside from the volatility in markets, there was little news of note out of the US last week
The dollar has been well supported since the Federal Reserve’s June meeting, which materially brought forward expectations for US interest rate hikes. Since then, FOMC officials have become increasingly more hawkish as inflation remains at very elevated levels and just shy of multi-decade highs. Continued bouts of risk aversion brought about by concerns surrounding the delta variant and rising inflation globally have further supported the greenback, and the US Dollar Index is currently trading just below its highest level in around a year. At the current pace, asset purchases will be wound down to zero in March, a few months earlier than initially planned. The minutes of the December meeting, released in early-January, indicated that some FOMC members even believed that the bank would soon need to begin reducing its balance sheet in a process known as quantitative tightening. According to the minutes, ‘the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalisation episode [in 2017]’, suggesting that the process could begin at some point in 2022.
The common currency spent December stuck within a very narrow range versus the US dollar. While the EUR/USD pair finally broke out of this range in mid-January, it has since slumped back into it.
Low euro volatility at the end of last year was surprising given the significance of the European Central Bank’s December announcement, and the reimposition of tougher virus restrictions in much of the common bloc. European nations have, on the whole, been among the most cautious of all the major economic areas with regards to the omicron variant. A handful of countries in the European continent tightened restrictions to a significant extent either side of the New Year, and that presents somewhat of a downside risk to the Eurozone economy in the immediate-term.
The pound ended last year higher against all of its major counterparts, aside from the Canadian and US dollars. We think that this outperformance was largely due to the UK’s successful vaccine rollout, the subsequent swift removal of all virus restrictions relative to most nations, and the hawkish stance adopted by the Bank of England, which unexpectedly raised interest rates in December. Sterling also made an impressive start to 2022, rallying to a two-and-a-half month high versus the dollar in mid-January. This move was helped along by the relaxation of virus restrictions in England, and expectations that the BoE will raise interest rates again at the next MPC meeting in February.