The Federal Reserve - will they hike or will they wait?

The Federal Reserve - will they hike or will they wait?               

• USD: US Treasury yields continue to rise with at one point, two full Fed 25bp rate hike implied by the end of 2022. The yield curve now implies a path where the Fed raises rates early, but not too far as the curve has flattened to price more Fed rate hikes in the near term while longer-term rates remain relatively low. The implied narrative from the UST yield curve is that the Fed will raise rates early and rapidly but stop at a relatively low level, allowing inflation to run at or just-above target. Citi analysts’ base case scenario on the other hand, is for Fed officials to operate in the “flexible average inflation targeting” regime and wait a bit longer to raise rates but then raise them further – implying higher nominal and real longer-term rates.             

• USD: Almost the entire 30bp move higher in UST 10Yr Treasuries yields since the September FOMC meeting has come in the form of rising market implied “breakeven” inflation. Relatedly, USD has not significantly strengthened against major currencies over the same period. The UST 10Yr real yield is  now just above -1.0%, up from -1.2% this summer but still not far from historic lows amidst the backdrop of an US economy where supply and demand imbalances are rapidly shifting and inflation has become more volatile. An early increase in Fed policy rates together with the tapering of asset purchases would raise real interest rates. This may lead market implied inflation expectations to fall, which might keep Fed officials from hiking as early or aggressively. Alternatively, Fed officials may wait a bit longer in which case expectations for longer-term inflation and/or real yields should rise.

• •USD: Citi analysts think it most likely Fed officials follow their new flexible average inflation targeting playbook and allow inflation to overshoot for longer, let inflation expectations rise further and raise rates later. This likely means a somewhat lower probability than priced of 2022 hikes but higher US real rates and inflation break evens priced later into the future – consistent the view that US long term yields likely continue to move higher.

RBA minutes acknowledge firmer growth but stick to a 2024 timeline on rates liftoff

• The RBA minutes released yesterday confirm the domestic economic recovery is firmer and together with the rebound in commodity prices and subsequent improvement in Australia’s terms of trade also sees local rates rising rapidly to now price the first RBA rate hike around mid 2022 and another one by the December 2022 to bring the cash rate to 0.5%. RBA Governor Lowe though continues to push back against such optimistic rates pricing by reminding investors that conditions for RBA lift-off (underlying inflation back within the RBA’s 2-3% target bank and the economy closer to full employment) are unlikely to be met until 2024 and he may once again emphasize this in a speech this Friday. However, the RBA is starting to look like the outlier in dollar-bloc central banks and Citi analysts think the RBA may need to bring forward its lift-off timeline to mid 2023, if not earlier.           

Data for the remainder of this week 

• GBP: UK CPI, Sep – Citi: 3.2% YY, prior: 3.2% YY; CPI Core, Sep – Citi: 2.9% YY, prior: 3.1% YY; CPI-H, Sep – Citi: 3.0% YY, prior: 3.0% YY – Citi analysts expect CPI to be steady in September and 0.2pp above BoE’s August forecast and expected to peak at 5.4% YY in Apr’22.

• GBP: UK Retail Sales, Sep – Citi: 1.0% MM, 0.0% YY, prior: -0.9% MM, 0.0% YY; Ex Auto Fuels, Sep – Citi: 0.3% MM, -1.6% YY, prior: -1.2% MM, -0.9% YY - BRC retail sales has fallen back further to 0.6% Y/Y, down from 3% in August. However, the CHAPS data points to a marginal increase in retail focused consumer spending. Citi analysts therefore expect only a very moderate increase in retail sales this month. The most notable feature could be a widening between growth for the series including and excluding retail sales. This primarily reflects the spike in fuel demand in the latter part of the month as concerns over supply began to grow. 

• EUR: German Manufacturing PMI, Oct Flash – Citi: 55.0, prior: 58.4; Services PMI, Oct Flash – Citi: 55.0, prior: 56.2 – the sharp rise in energy prices as well as uncertainty regarding the Chinese growth outlook are likely to pose headwinds to parts of the manufacturing sector. However, Citi analysts expect some relief about the 26 September election result (notably that a left-wing alliance is not possible) but offset by supply constraints and price hikes that will likely dominate the picture in October confidence surveys.

• EUR: Euro area Manufacturing PMI, Oct Flash – Citi: 57.0, prior: 58.7; Services PMI, Oct Flash – Citi: 55.5, prior: 56.3; Composite PMI, Oct Flash – Citi: 55.0, prior: 56.1 – Citi analysts estimate the flash composite PMI likely softened for the 3rd successive month, consistent with a gradual deceleration in pace of economic expansion as GDP closes in on its pre-pandemic level.

• GBP: UK Manufacturing PMI, Oct Flash – Citi: 56.5, Sep Final: 57.1; Services PMI, Oct Flash – Citi: 54.4, Sep Final: 55.4 – production and new orders have both fallen back, while employment and business optimism have also moderated. Meanwhile, output prices continue to grow at a near-record rate. Any sign of further pressures is likely to be the focus. Also important will be commentary on the impact of end of furlough on employment.

• GBP: UK Services PMI, Oct Flash – Citi: 54.4, Sep Final: 55.4 – Citi analysts expect growth in the UK services sector to fall back in October. Business optimism has fallen to its lowest level since January while outstanding business, employment and backlogs have also fallen back. Meanwhile, input and output prices both continue to accelerate and any signs of more generalized wage/ labor cost pressures could yet provide ammunition for BoE hawks.

• CAD: Canada September CPI NSA MoM (Sep) – Citi: 0.3%, median: 0.1%, prior: 0.2%; CPI YoY – Citi: 4.5%, median: 4.3%, prior: 4.1% - Citi analysts expect another strong increase in consumer prices in September and expect BoC to increasingly acknowledge the persistence of high inflation and its willingness to act, which likely presents hawkish risks ahead of next week’s October meeting.

• CAD: Canada August Retail Sales MoM (Aug) – Citi: 1.4%, median: 1.9%, prior: -0.6%; Retail Sales ex Auto MoM – Citi: 2.8%, median: 2.4%, prior: -1.0% - There should be strong spending in sales excluding autos that reflects still-strong demand for goods as activity picks up, with some increase in nominal sales also potentially a reflection of higher prices. That said, there may be some continued downside risks for monthly retail sales in August, however, as consumption shifts away from goods and back toward services. 

This is an extract from the Daily Currency Update, dated October 20, 2021. Please approach a Citigold Relationship Manager if you would like more information. For the latest updated CitiFX house views and strategy (updated every Monday) please click here - 

 https://asia.citi.com/wealthinsights/citifx-house-views-and-strategy