Shane O'Neill, Head of Interest Rate Trading
Over the last week, we have seen two major central banks come to market and what could be the beginning of a new period for monetary policy. The time of concerted inflation fighting sounds like it is coming to an end, or a pause, and with it goes the certainty of action. While central bank hikes were previously telegraphed and 100% priced by markets well ahead of time, we now find ourselves scrutinising every data release and press conference utterance. The knock-on effect of these developments will be a period heightened market volatility, the signs of which have already become evident.
The Fed was the first to come to market, hiking rates as expected by 25bps and taking the upper bound to 5.5% – the highest level in 22 years. The messaging surrounding the hike was taken as fence sitting by markets – Chairman Powell stated that it was too early to decide whether this was the final hike in the cycle or not – and remains unclear. Future hikes, we are told, are data dependent but since the June meeting – during which rates were kept on hold – headline inflation has fallen quite markedly. This leaves markets in a difficult position, as data progress is clearly important but also, presumably, not the be all and end all.
The ECB was next and again, the meeting was marked by a lack of commitment, despite hiking to 3.75%. The President Lagarde of meetings gone by – the assertive inflation warrior – came across a lot less sure this time around. She acknowledged that the job of tackling inflation is probably not done yet but that future hikes would be data dependent. And if this wasn’t enough uncertainty, she added: "There is the possibility of a hike [next time]. There is the possibility of a pause. It's a decisive maybe." In the days following the meeting, Lagarde doubled down on this flexibility (read, uncertainty) – telling Le Figaro newspaper that, “a pause, whenever it occurs, in September or later, would not necessarily be definitive.”
Both the ECB and the Fed are fostering this uncertainty – acknowledging that inflation still has further to fall but wavering economic conditions may necessitate a pause or even a cut. As we near the end of the hiking cycle, this flexibility is required if they are to have any chance to manoeuvre us into a soft landing. But the effects on the market are significant and will impact risk managers.
We need only look at market pricing for future hikes to see the new rhetoric manifest itself – at the end of June the next ECB meeting had an almost 70% chance of a hike priced in, but this has fallen to close to 45%. As market pricing moves toward a “coin flip”, the knock-on effect is elevated volatility and accentuated moves, particularly around important data points and central banks’ speeches.
Such moves have already begun to materialise. In the hours following President Lagarde’s press conference, EUR weakened against the USD by 1.1%, the largest move since March this year. And in the minutes following the most recent US GDP figures, which outperformed market expectations, the USD index climbed by almost 1.2%.
We can expect this environment to persist in the coming weeks. In the next week alone, we have the BoE coming to market, with expectations for a similarly aggressive pivot toward data dependency, and there are big data points on the horizon too, with US labour market releases coming at the end of the week.
Risk managers, where relevant, may wish to consider FX options. Whilst realised volatilities have begun to pick up, implied volatility (the main driver of option prices) has remained subdued. Indeed, in both EURUSD and GBPUSD implied vols for 1y options are falling and currently sit at the most attractive levels seen since mid-2022. A changing market environment can call for a rethinking of hedging practices – those with a framework in place will find adjusting and altering practices considerably easier and it may just make all the difference.
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