Between Facebook’s weak earnings and negative guidance, a rate hike from the Bank of England and concerns about inflation from the European Central Bank, it proved to be a very lively day in the forex market. EUR and GBP soared on the back of the rate decisions, with EUR/USD jumping more than a cent. Although stocks traded lower, risk currencies were in demand as the global tightening cycle fuelled an appetite for yield. Thanks to a sharp rise in Treasury yields, EUR/JPY and NZD/JPY were among the day’s best performers.
Although the Bank of England raised interest rates and the European Central Bank left monetary policy unchanged, EUR outperformed GBP four-fold because the 25bp rate hike was expected from the BoE. And, as we wrote yesterday, some market participants hoped for a 50bp move. In some ways, the move by the BoE was more disappointing than the guidance from the ECB even though it was the first back-to-back BoE rate hike since 2004. Highlighting the division within the central bank, four of the nine members favored a larger move, but the five-member majority, including Governor Andrew Bailey felt that because of weakening growth it made more sense to move in 25bp increments. The central bank will also begin reducing the size of its bond holdings. It is clear that more rate hikes are on the way for the Bank of England, but today’s vote for a more incremental move is a sign of a measured approach.
Never underestimate the power of short covering. We saw a lot of that today in EUR/USD and more could follow – 1.15 is an important level that we expect to be tested and broken. While many market participants hoped that the ECB would acknowledge the rise in price pressures, it was unclear how hawkish it would be given ECB President Christine Lagarde’s recent comment that the central bank did not need to act like the Federal Reserve. But today, she opened the door to tightening by saying:
“Inflation is likely to remain elevated for longer than previously expected…. Compared with our expectations in December, risks to the inflation outlook are tilted to the upside, particularly in the near term.”
Most importantly, she added: “The situation has indeed changed.”
She did not repeat that a rate hike this year is “very unlikely.”
According to ECB sources, a year-end rate hike is on the table. So while the ECB left policy unchanged, these not-so-subtle changes in guidance were significant enough to renew demand for euros. The market is now pricing in as much as 50bp of tightening by December.
Looking ahead, U.S. and Canadian job reports are scheduled for release on Friday. Despite the recovery in USD/JPY and the rise in Treasury yields, traders should be mindful of the risks of a weak report. The slowdown in the service sector in the month of January was due, in part, to weaker job growth. The employment component of ISM services dropped to 52.3 from 54.7, its weakest level since October. This follows the first drop in private sector payroll growth since December 2004, according to ADP. The four-week moving average of jobless claims is also higher in January than in December, and the University of Michigan index fell to a decade low. Although the manufacturing sector added jobs and continuing claims declined, this won’t be enough to offset the downside risk. Economists are looking for non-farm payrolls growth to slow to 150,000 from 199,000. A soft report may not deter the Fed from tightening in March, but it could certainly give euro bulls a stronger case to sell U.S. dollars.
Here’s are the arguments for weaker vs. stronger January non-farm payrolls:
Arguments For Weaker January Non-Farm Payrolls
1. ISM Services Employment Component declines
2. First drop in ADP Employment Change since December 2004
3. Higher 4-Week Jobless Claims Average
4. University of Michigan Consumer Sentiment Index sinks to decade low
5. Lower Consumer Confidence Index
Arguments For Stronger January Non-Farm Payrolls
1. Lower Continuing Claims
2. ISM Manufacturing Employment Component rises
3. Steady Job cuts reported by Challenger
Weaker job growth is also expected for Canada. The labor market has been very strong with consistent upside surprises in recent months. The Omicron scare along with renewed restrictions is expected to bring about the first month of job losses since May 2021.