Rate Hikes Are Back on the Table. What Does That Mean for Currency Markets?

Last week’s main focus was the Japanese Yen and the US Dollar, with USD/JPY briefly reaching the 160.00 level on Monday. This immediately put markets on alert for potential intervention, particularly given how sensitive Japanese authorities have been to rapid Yen weakness around these levels. By Tuesday the conversation had already shifted towards the prospect of the Bank of Japan raising interest rates by 25 basis points in September, helping the Yen recover and pushing USD/JPY back towards 157.00.

Friday then brought the highly anticipated US Non-Farm Payrolls report, which showed 162,000 jobs added in August, comfortably ahead of expectations. On the face of it, this was a strong report and a decent recovery after several poor months for the US labour market. It also pushed expectations for a September Federal Reserve rate hike higher, with markets ending the week pricing the probability at around 60%.

Digging a little deeper, though, I don’t think the report was quite as strong as the headline suggested. Leisure and hospitality added 62,000 jobs, while local government education added another 42,000, meaning those two areas alone accounted for almost two-thirds of the overall increase. Wage growth also eased to 3.1% year-on-year from 3.2% previously. The report certainly keeps a September hike on the table, but I still think the Fed’s decision will ultimately come down to this week’s inflation numbers.

The new week begins quietly, particularly with US markets closed on Monday for Labor Day. In Europe, however, we get the latest Eurozone GDP and employment figures. GDP growth is expected to be confirmed at 0.4% quarter-on-quarter, while annual employment growth is expected to remain at 0.5%. Neither release would normally be enough to move markets significantly on its own, but with the ECB meeting later in the week and inflation having risen to 3.3%, the European data is becoming increasingly important.

Tuesday begins with the final reading of Japanese second-quarter GDP. Annualised growth is expected to be revised down from 1.8% to around 1.1%, with quarterly growth revised from 0.5% to 0.3%. Given the amount of attention now being paid to a potential Bank of Japan rate hike, a weaker GDP number could take some of the momentum out of the Yen’s recent recovery. If the BoJ is considering raising rates again, it will need to balance its inflation concerns against an economy that may not be growing as strongly as previously thought.

Thursday brings one of the biggest events of the week with the ECB interest-rate decision. Markets broadly expect the ECB to raise its deposit rate by 25 basis points from 2.25% to 2.50%, following the recent rise in Eurozone inflation. Headline inflation reached 3.3% in August, largely because of higher energy prices, although core inflation actually eased slightly to 2.4%.

Because a rate increase is already widely expected, I think the more important part of Thursday’s meeting will be what the ECB says about what comes next. A 25-basis-point increase on its own may not be enough to generate sustained Euro strength if Christine Lagarde then suggests the Bank is comfortable pausing. On the other hand, if the ECB remains concerned about inflation and leaves the door open to further tightening, the Euro could have more room to strengthen.

Later on Thursday we move back to the US with Producer Price Index inflation and weekly jobless claims. PPI is expected to show another monthly increase and will give us an early indication of inflationary pressure before the much more important consumer inflation figures arrive the following day.

Friday is finally a more UK-focused day, starting with the latest monthly GDP figure. The UK economy grew by 0.3% in June, but July is currently expected to show no growth. A 0.0% reading would not necessarily be disastrous, but it would reinforce the fairly subdued picture for the UK economy and could weigh on Sterling, particularly if the accompanying production figures disappoint.

We will also get UK trade balance, industrial production and manufacturing production figures. Some of those numbers are expected to improve from the previous month, so there is a chance that the wider report looks slightly better than the headline GDP figure suggests.

The main event on Friday, though, will undoubtedly be US CPI.

Headline inflation is currently expected to remain around 3.4% year-on-year, while core inflation is expected to ease towards 2.4%. After Jackson Hole and Friday’s stronger employment report, this is probably the most important US data release before the Federal Reserve meets on 15 and 16 September.

For me, this is the number that could ultimately decide whether the Fed hikes this month. The labour market has just shown that it is stronger than many expected, which gives the Fed more room to concentrate on inflation. If CPI comes in hotter than expected, particularly within the underlying components, the argument for another 25-basis-point increase becomes considerably stronger. If inflation continues to soften, however, I still think there is a reasonable argument for the Fed to hold rather than raise rates simply because one employment report came in strongly.

That makes this an interesting week for all three of the Dollar, Euro and Yen. We have gone from questioning the strength of the US labour market to debating whether the Fed should raise rates again, while both the ECB and Bank of Japan are dealing with their own arguments for tighter policy. By Friday afternoon, we should have a much clearer idea of which of those central banks genuinely has the strongest case for another rate increase and, ultimately, where the next move in the major currencies is likely to come from.

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