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European Monetary Policy and FX Roundup

Summary

It has been a particularly busy week across Europe, with several of the G10 central banks making monetary policy announcements and contributing to varying degrees of market excitement. In this report we briefly recap these announcements and assess their FX implications.

Norway’s central bank became the first G10 central bank to raise rates with a 25 bps rate hike as the economy returns to a more normal growth path. While the central bank’s projections signaled further rate hikes, the increases penciled in for 2022 still look a touch light to us. We see upside risk to our current forecast of Norwegian krone appreciation.

The Bank of England held monetary policy steady and, despite cross-currents affecting the U.K. economy, said the case for modest tightening has potentially strengthened. With the announcement we have brought forward our expected timing for rate increases, and we now expect the Bank of England to initiate a rate hike cycle with an increase in May 2022, followed by November 2022. While the pound may be subject to some near-term uncertainties, we expect the U.K. currency to strengthen against the U.S dollar and the euro over the medium-term.

Sweden’s central bank and Switzerland’s central bank both held monetary policy steady, with no indication either central bank will move to a less accommodative monetary policy stance for the foreseeable future. Given the strength of Sweden’s economic rebound we still anticipate modest Swedish krona strength versus the euro. For Switzerland, moderate Swiss growth and inflation, combination with some improvement in global economic and market sentiment over time, should see the franc soften versus the euro.

Norway’s Central Bank Kicks Off G10 Rate Hike Cycle

The Norges Bank, Norway’s central bank, became the first developed economy central bank to raise interest rates during the current cycle, lifting its Deposit rate by 25 bps to 0.25%. The move was widely expected by market participants, and was justified by the central bank on the back of firming growth rather than inflation concerns per se. The Norges Bank said a “normalising economy now suggests that it is appropriate to begin a gradual normalisation of the policy rate”, and added that while underlying inflation is low increased activity and rising wages should push it towards 2%.

The Norges Bank’s updated projections anticipate further normalization of the economy, with the mainland GDP growth forecast at 3.9% for 2021 (versus 3.8% previously) and 4.5% for 2022 (4.1% previously). The interest rate path contained within those projections is also slightly higher than previously. In its announcement, the Norges Bank explicitly stated the policy rate would most likely be raised further in December, while the revised rate path sees the policy rate rising to 1.12% by Q4-2022. We are in agreement on a December 2021 rate increase. However, given we also expect a solid ongoing economic rebound, the rate path for next year still appears to be a touch light. We expect at least a further 75 bps of rate increase, and perhaps as much as 100 bps of rate increase, in 2022. Against this growth and monetary policy backdrop we believe the risks around our Norwegian krone forecast are tilted towards a faster pace of appreciation relative to our base case, which anticipated a EUR/NOK exchange rate of NOK9.95 by the end of next year.

Bank of England Still Moving Towards 2022 Tightening

The Bank of England (BoE) held monetary steady at its September meeting, although the announcement was arguably marginally hawkish in tone. Policymakers voted unanimously to hold its policy rate steady at 0.10%, while there was a 7-2 vote to continue with the government bond purchase programme, with the two dissenters voting for an early end to asset purchases. That was a slight change from previous meetings which has seen just one dissent in favor of an early end to bond purchases.

The Bank of England’s statement highlighted cross currents affecting the U.K. economy contributing to softer growth (for now) and higher inflation. The central bank said the forecast for the level of real GDP in Q3-2021 has been revised down around 1% since its August projections, noting some supply disruptions. Moreover, while the BoE noted softness in reported retail sales it said other indicators of spending have remained stronger. On inflation, the central bank cited increased natural gas prices as an upside risk and said cost pressures are still elevated, even if they are likely to be transitory.

Importantly, with respect to overall monetary policy the Bank of England said:

“At its previous meeting, the Committee judged that, should the economy evolve broadly in line with the central projections in the August Monetary Policy Report, some modest tightening of monetary policy over the forecast period was likely to be necessary to be consistent with meeting the inflation target sustainably in the medium term. Some developments during the intervening period appear to have strengthened that case, although considerable uncertainties remain.”

From our perspective, while the uptick of inflation will very likely be transitory, it is somewhat challenging to discern how much of the current spike in inflation is temporary and how much is more persistent. In August for example, we note the headline, core and services CPI all showed an increase of 3.0% year-over-year or greater. By 2022 we expect the U.K. economy will have returned to a steadier growth path and CPI will still be above target (even if it is slowing). As a result, we still expect the Bank of England to begin raising rates around the middle of next year. In fact, with today’s announcement we have brought forward our expected timing of Bank of England rate hikes by a quarter, and now anticipate a 15 bps policy rate hike in May 2022 (to 0.25%) and a 25 bps rate hike in November (to 0.50%). While the pound could be subject to some near-term uncertainty, we still expect the U.K. currency to strengthen against both the U.S. dollar and the euro over the medium term. Our current year-end 2022 targets are $1.4300 for the GBP/USD exchange rate a EUR/GBP exchange rate of 0.8325.