UK and Global Interest Rate Debate Dominates the Pound, Risk Rebound Rescues GBP/USD Exchange Rate from 3-Month Lows
The ECB increased interest rates by 25 basis points at the latest policy meeting with the deposit rate at 4.00% and the refi rate at 4.50%.
The bank also signalled that interest rates are high enough to bring inflation under control which suggested strongly that rates have peaked.
The Euro briefly spiked higher after the rate hike, but the market quickly reversed course and the single currency posted significant losses.
The Euro to Dollar (EUR/USD) exchange rate dipped to 6-month lows close to 1.0630 before rallying to 1.0665.
The Pound to Dollar (GBP/USD) exchange rate also dipped to fresh 3-month lows just below 1.2400 before a tentative recovery to 1.2435 as equities made headway.
The Pound to Euro (GBP/EUR) exchange rate found support just above 1.1600 and strengthened to 1.1660.
Shift in ECB Expectations Poses Risks
Socgen is not convinced that the shift in ECB guidance is a sensible move as it could force a reversal next year.
It noted; “Unfortunately, in our view, stating this so clearly raises the risk that markets will now increasingly focus on the timing of the first cut, especially as inflation is likely to come down and growth remains sluggish.”
It adds; “We also see a clear risk that high unit labour costs will result in sticky core inflation, which the ECB may need to react to with rate hikes next year.”
This would risk a fresh slide in confidence in the outlook.
ING expects guidance will be a key element with the ECB resisting talk of rate cuts. It notes; “Lagarde has probably switched from a near-term hawkish narrative to defending a higher-for-longer approach to combat inflation: expect some pushback against rate cut speculation if eurozone data deteriorate further.”
According to MUFG, the dovish market reaction to the policy highlight that the signal that interest rates have peaked and that the overall Euro-Zone outlook remains bleak.
Credit Agricole considers that further Euro selling should be contained; “Looking ahead, however, we think that the EUR/USD outlook could be more balanced in part because we believe that many EUR-negatives are already in the price.”
The ECB move also had important ramifications for global markets.
The generally soft data this week has undermined the case for the Bank of England to increase interest rates aggressively from current levels, especially with evidence of a softer labour market.
International developments were also important on Thursday with the ECB signal that interest rates have reached a peak level also having a wider impact, especially on UK expectations.
Overall, there was increased speculation that the Bank of England would also accompany an interest rate hike next week with a signal that rates are now high enough.
According to ING; The dovish tilt by the ECB likely added fuel to the ongoing dovish re-pricing of Bank of England rate expectations, and markets now price in only 34bp to a peak, a 40bp correction over the past month.”
MUFG commented; "Momentum is to the downside in the near-term. What's driving the pound gradually lower is that markets are gradually paring back their rate hike bets.”
Expectations of peak ECB interest rates had a significant impact in underpinning risk appetite with gains in global equity markets.
The improvement in risk appetite also had a significant positive impact on the Pound as the UK FTSE 100 index posted a 3-month high.
In general terms, the Pound will tend to gain support from stronger risk conditions.
The Federal Reserve will announce its latest policy decision next week.
There are very strong expectations that the central bank will maintain interest rates at 5.50% with less than a 5% chance of a further rate hike.
Expectations surrounding the outlook will also be a key element with Fed guidance watched closely.
At present, markets are pricing in just over a 30% chance that the central bank will increase rates at the November meeting.
Hawkish guidance and interest rate forecasts still showing a further rate increase this year would tend to increase market pricing of a rate hike.
According to ING; “While the Fed is expected to leave rates on hold next week, the updated guidance will be watched closely to see if the Fed sticks to plans for one final rate hike this year which if sustained could add to the US dollar’s appeal.”
HSBC notes the risk of a US government shutdown which could undermine dollar confidence. It notes; “The risk of a US government shutdown appears to be very much alive, after a defence spending bill – a Republican bill – was pulled from a vote late yesterday because of objections by GOP hardliners.”