The Perfect Storm in Sight

World Markets

As the UK returns from a long weekend celebrating the Queens Platinum Jubilee, many headwinds are already setting the tone for the week ahead.

Prime Minister Boris Johnson will face a vote of confidence later today after the British leader was booed at various events over the past few days. Johnson, appointed prime minister in 2019, has been under growing pressure, unable to move on from a damaging report over parties held in his Downing Street office and residence when Britain was under strict COVID-19 lockdowns. If Johnson loses a confidence vote, he would be removed as prime minister and there would be a leadership contest to decide his replacement. In fact, there’s a growing risk the nation’s current account deficit, political turmoil, a deterioration of its relationship with the European Union over Northern Ireland and questions around the central bank’s credibility combine to create a “perfect storm.”

On the European front, equities ended last week on a negative note as data showed the U.S. economy added 390,000 jobs in May. This was more than expected and prompted investors to reassess the potential for rising interest rate hikes by the Federal Reserve in the months ahead. With this in mind, investors are keenly awaiting the release of Friday’s U.S. CPI report for May as this will act as a key input before the Fed decides how much to hike rates next week. Ahead of this, the European Central Bank meets on Thursday and is expected to use this get-together to make clear that rate hikes will be coming in the third quarter.

It’s not the first time in recent years Wall Street strategists have drawn parallels between the British currency and emerging markets. The comparison was made amid the UK’s torturous exit from the European Union, where political headlines whipsawed sterling as its behaviour broke from major peers.

Whilst not wishing to over-exaggerate GBP’s predicament as some kind of ‘end-of-days’ scenario, there are concerns that the increasing politicization of UK policy undermines the GBP in ways that would appear EM-like. There is a sense that something is changing in the UK, with the BOE increasingly hard to decipher and less transparent; a failure to discuss and acknowledge that Brexit has been a significant headwind to the supply side; and a sense that the BOE is losing control over its mandate.

In fact, the BOE has faced political attacks this month over its response to inflation, which is at its fastest rate in four decades. Despite four interest-rate increases since December and money markets bracing for more in each of its next five decisions, the pound is the third-worst performing major currency this year. At a point of increased uncertainty over domestic growth, signs of regional fragmentation and Northern Ireland-related risks, the UK will find it increasingly difficult to attract portfolio flows to finance a widening current-account deficit.

Top of the agenda for many market participants this week is Thursday’s meeting by the European Central Bank, which is expected to prepare the ground for an interest rate hike at its July meeting. While central banks around the world have begun their rate hike cycle, the ECB is seen as a step or two away from it. Eurozone inflation hitting record highs, though, has added more urgency to the discussion, and analysts expect this meeting to make clear that rate hikes will be coming in Q3. ECB president Christine Lagarde said as much in a blog post two weeks ago, so both the ECB statement and the press conference to follow will provide a chance for Lagarde to elucidate the road back to positive interest rates and to re-affirm the bank’s credibility. As of writing, market participants are currently pricing in a 125-basis point hike at the ECB’s four meetings this year. In fact, the EUR/USD rose 1.67% since the end of April and 3.55% from mid-May lows, suggesting the bank has re-won at least a little bit of that credibility with markets.

Friday’s U.S. CPI report for May comes a few days before the next Federal Reserve meeting and will act as a final input before the Fed decides how much to hike rates. Inflation is expected to come in at 8.3% year over year, while core inflation (excluding energy and fuel prices) is expected to come in at 5.9% year over year. The latter number would mark the third month of consecutive declines and make the case that core inflation may have peaked, which would echo the slower wage growth in last week’s jobs report. At the same time, the overall inflation number of 8.3% would be close to the peak and given the pain at gas pumps and grocery stores, consumers may take little solace in knowing the core number is levelling out.