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UK Weekly Market Analyis
Renzi & Draghi: Super Marios Drive Euro Volatility

David Starkey December 9, 2016

– ECB surprises markets, announces 2017 taper

– UK CPI poised to leap higher on food prices

– With US rate hike virtually given, eyes are on 2017 outlook

 

The big story this week has been the euro, which has been especially volatile following last weekend’s Italian Referendum and Thursday’s European central Bank monetary policy update. Political uncertainty saw the common currency start the week on the defensive after Italian voters rejected proposed constitutional reforms, which in turn saw Prime Minister Mario Renzi step down. The euro slipped briefly to its 5-month and 21-month lows against the pound and greenback respectively.

Choppy trading continued through the week, with large swings in both directions leading up to and in the aftermath of Thursday’s ECB monetary policy update. ECB President Mario Draghi announced that the QE program as we know it will continue until March 2017, as per previously guidance. However, seemingly capitulating to recent criticism about QE’s detrimental bearing on savers, Draghi revealed that starting in April asset purchases will shrink from €80bn to €60bn per month. At a press conference after the announcement Draghi reiterated that despite the reduction in QE, the ECB is committed to nursing the Eurozone economy back to health. The shock policy tightening for 2017 could be a sign that Team Draghi could be running out of ammunition in its ongoing war against weak inflation in the Eurozone. Much of the euro’s weakness in recent years has been a function of market expectations that ECB policy stimulus will continue until it’s no longer needed. If that view changes, the euro could find itself supported in the months ahead.

It’s an exceptionally busy week ahead, with plenty of key fundamental economic data and central bank activity on the docket. The headline event is Wednesday’s Federal Reserve Monetary policy update and official outlook. Data in the United States have been encouraging of late. The labour market remains tight, inflation is starting to edge higher, GDP is at target levels, and consumer sentiment is steady near pre-financial crisis levels. As such, the argument for current emergency levels of monetary stimulus is weak. This has led to an interest rate hike being fully priced in for next week; in fact, if one doesn’t materialize it would be a surprise that could sink USD.

The real question is what the Fed’s 2017 outlook is and how many possible rate hikes can be expected. If monetary stimulus remains loose, there’s a risk the economy will overheat and then crash. If the taps get shut off too quickly, it would be detrimental to the both consumers & businesses, in turn stalling the economy. It’s a delicate tight rope that Fed chair Janet Yellen is going to have to walk. Financial markets are pricing in about a 30% chance of 2 subsequent rate hikes in 2017. USD’s response next week could be dictated by how much official guidance confirms or contradicts the market view. If Yellen and her team nod to two or more rate hikes, the greenback, which his already trading near 13-year highs, could find itself pushed even higher.

Outside of the Fed, both the Bank of England and the Swiss National Bank are updating monetary policy. No change is expected from either institution. However, given British inflation’s pop higher during the post-Brexit period, the BoE’s Monetary Policy Summary will be closely analyzed. Incidentally, next week November British inflation numbers will be published; special attention will be paid to the food prices contribution. Increasing food prices, as a function of recent sterling weakness could be a headache for BoE Governor Mark Carney. Carney would prefer to keep monetary policy loose during Brexit negotiations to support the domestic economy during uncertain times. However, higher than expected prices growth could mean that the BoE is forced to choose either accommodative policy & and GDP growth or tighter policy and controlled inflation. If inflation looks to be getting out of control and less accommodative policy adopted, sterling could be supported in the short term.