As many Europeans continue to enjoy their summer breaks, their mood can be lifted by expectations that peak rates loom in the horizon. In July, the ECB hiked the deposit rate to 3.75%, as expected, but at the press conference, President Lagarde opted for a clearly dovish tone. Service sector, the prime engine for economic growth in Europe this year, has started to lose steam, and the ECB is clearly more concerned about growth than before. As it is evident the ECB has now entered the fine-tuning phase in its policy tightening, Lagarde emphasized that they could hike rates again in September, or they could choose to pause, depending on the upcoming data. Furthermore, if they pause in September, they could still hike later on, if necessary. We keep our call of one more hike in September, read more on Flash ECB Review – A decisive maybe, 27 July.
After pausing in June, the Federal Reserve also delivered a 25bp hike in July to 5.25-5.50%. No doubt the US economy has performed better than expected lately. Nevertheless, as there are clear signs of inflation now starting to stabilise to levels consistent with the central bank’s 2% mandate, we think this was the final hike of the cycle (see Research US – Fed Review: Balancing act with focus on data, 26 July). The BoE also delivered according to expectations and hiked the policy rate by 25bp, bringing the bank rate to 5.25%. We expect one more hike in September and stay negative on GBP.
Boosted by expectations of rates peaking in near future, the US stock market rallied in June-July with the S&P500 rising 10%, converging with European stocks that have been outperforming since last November. Until now, high inflation has led to a rising corporate profit share at the cost of earners, which makes sense since selling prices move more flexibly than wages. Going forward, however, corporate profits will have to absorb the increases in wages, if inflation is to be tamed. Alternatively, corporates maintain their pricing power, passing through rising wage costs to prices, in which case inflation could again prove stickier than expected. In this light, could it be that the markets are relying on a central bank pivot that will not happen, not as soon as the markets expect anyway?
Risk market rally also drove a weaker in USD in early July, and EUR/USD hit a 16-month high before changing course around mid-month. We still like our strategic call for a weaker EUR/USD (see FX Forecast Update – holiday edition: Q3 to mark peak in policy rates, 17 July). This week, energy sector concerns have again raised their head after news of a planned strike at Australian LNG plants led to a spike in gas prices.
The Bank of Japan surprised the markets in July by keeping its yield curve control (YCC) but announcing they would allow long-term interest rates to rise up to 1%. The practical modalities were likely intentionally left vague, but at least the BoJ can now choose not to intervene in the market if pressure builds up for higher yields. We expect a gradual easing of the YCC in the course of the autumn.
Next week, focus will be on US July retail sales and other real sector data. FOMC minutes will be released on Wednesday. In euro area, we keep an eye on the ZEW index on Tuesday and the final July HICP print due on Friday.
