April Review

Dollar strength

According to one Bloomberg dollar index, the dollar has already gained 4% this year. Robust economic data, a hawkish interest rate outlook, and ongoing geopolitical tensions in the Middle East have supported the currency to its strongest position since 2019. 

The shift has been described as "unusually broad", with the dollar gaining against every major currency and around two-thirds of the 150 global currencies tracked in the mainstream. This narrative is far from the expected decline the markets forecasted at the beginning of the year.

The dollar's strength has far-reaching implications worldwide. Much of the global economy runs on the dollar—in April 2022, it was involved in 88% of all currency trades, and between 1999 and 2019, it accounted for nearly 80% of trade invoicing worldwide and 60% of all international deposits and loans. It's also the world's reserve currency. 

The impact is variable, but many countries may need to buy dollars more of their domestic currency for their international trades, and any dollar loan repayments become more expensive. The phenomenon can lead to what the Federal Reserve calls the 'Imperial Circle', which describes a situation whereby when the dollar appreciates, it causes a slowdown in global trade and overall growth in an ongoing cycle until its broken.

The big market mover over the past month, both in foreign exchange and other financial markets, has been the reduction in expected interest rate cuts from the US Federal Reserve this year. 

In January, the market was pricing in US interest rate cuts of 1.0 and 1.5% this year, while now markets expect less than 0.5%. That change in expectation makes the US dollar more attractive to invest in over this year, and therefore, the US dollar index has strengthened close to the highs we saw in 2023. This could have contributed heavily to GBP/USD dropping to 1.2301 in April.

In the UK, the narrative around interest rate cuts has been less clear-cut. Earlier in April, Megan Greene, one of the more hawkish members of the Bank of England, touched on the possibility of rate cuts in a Financial Times column, saying, "In my view, rate cuts in the UK should still be a way off". Market expectations for the first rate cut moved from August to September, and the forecast for quarter-point cuts for the year fell to two at around the same time.

The following week, the Deputy Governor of the Bank of England, Dave Ramsden, highlighted easing price pressures in the UK, which could have suggested that he has become more open to the possibility of an interest rate cut sooner rather than later in the UK.

During his speech, Ramsden appeared more relaxed on upcoming changes to interest rates in the UK, highlighting the fall in Consumer Price Indexes released earlier in the week and the trend of reducing price inflation for the UK that the CPI data has shown steadily since Autumn 2023. This, in his opinion, will see UK inflation heading back towards the Bank of England's targeted 2% range. 

The reiteration held particular weight, given comments from Bank Governor Andrew Bailey earlier in the week, who also stated that there is strong evidence that UK inflation is falling. Their sentiments caused some economists to speculate the first interest cut could be seen as early as June.

The European Central Bank held the only rate decision in April, maintaining its rates for the fifth consecutive meeting but appearing to hint at a potential rate cut in June. The ECB President, Christine Lagarde, stated, "It would be appropriate to reduce the current level of monetary policy restriction" if inflation continues to move toward its 2% target. 

She also nodded to the higher-than-expected CPI inflation data released in the US, saying, "We are not assuming that what happens in the euro area will be the mirror of what happens in the United States." The European Central Bank’s consistent rhetoric appears to have helped stabilise expectations around interest rate changes in the Eurozone, providing more stability to the currency as a whole. 

May Outlook

Federal Reserve

With a host of US economic data points beating expectations and the US election coming up in November, the reality could be even less than 0.5% in interest rate cuts this year. If this narrative grows, it could further strengthen the USD through the next six months.

The US CPI inflation figure on 15th May could again drive USD volatility mid-month when it is anticipated that the pattern towards slightly higher inflation is set to continue. This is the first of two CPI inflation data releases before the next Federal Reserve meeting, the second of which will happen the morning policymakers make their rate decision.

This month also sees a flurry of central bank meetings. The first came on Wednesday last week when the Federal Reserve policymakers opted to hold rates steady, in line with market expectations. 

The Fed's Chair Jerome Powell signalled rates would stay higher for longer after a run of sticky inflation in the US. Powell spoke of "a lack of further progress" towards its inflation target and said, "It is likely to take longer for us to gain confidence that we are on a sustainable path to 2% inflation". 

This was new language from the central bank and could mean that rate cuts will be delayed until later in the year. Markets now anticipate between one and two rate cuts from the Fed this year, with the first expected in November.

USD has strengthened significantly over the past few weeks because of markets reducing bets on US interest rate cuts. This has increased the buying of USD, which could contribute to US interest rates staying higher for longer – potentially significantly higher than UK and EU interest rates if current expectations play out.

The Bank of England

The Bank of England held rates steady as expected last week. Interest rates have remained at the 16-year high of 5.25% for the last six meetings as the central bank's monetary policymakers wait for the threat of high inflation to diminish.

While the rates remained unchanged, the focus was on the Bank of England's accompanying commentary, which markets hoped would provide a glimpse into the central bank's potential actions in the coming months.

Governor Andrew Bailey's comments were described as more optimistic, hinting at a possible rate cut in June. He stated that a cut at the next meeting was neither "ruled out" nor "fait accompli", and it was "likely that we will need to cut bank rates over the coming quarter, possibly more than currently priced into market rates."

Another notable deviation from previous meetings was the voting split. Seven members of the Monetary Policy Committee voted in favour of holding rates, with two voting for an immediate rate cut, a change from the eight to one split in the last meeting. Markets are now divided on what to expect from June’s MPC meeting, with the probability of a cut currently standing at over 50%.

The Bank of England is anticipated to cut interest rates twice this year from the current 5.25% by around 0.50% to 4.75%; however, as we have seen from the US interest rate expectations, this can change very quickly depending on economic data releases which could have a significant knock-on effect on FX markets. 

Away from interest rates, the Office of National Statistics released the first quarterly estimate for UK GDP last Friday, which estimated economic growth of 0.6% January-March. The estimates also reflect 0.2% growth compared to the same quarter one year ago. The ONS data indicates that the UK has come out the technical recession it entered into at the end of 2023. 

UK CPI inflation dropped to 3.2% in March (released in April), and the next reading is set for 22nd May. The markets and the Bank of England will also be watching this figure very closely, and it could cause some GBP volatility in the second half of the month.

Data sourced from Bloomberg

This commentary does not constitute financial advice and all quoted rates are sourced from Bloomberg.