Central Bank Belt Tightening Set for Q3

Led by the Federal Reserve, major central banks are set for more monetary belt tightening in the third quarter.

Currency traders may have to price in another 0.75 percent interest rate hike in the US towards the end of July. Meanwhile, the ECB is likely to hike its key interest rate from sub-zero territory for the first time in 11 years. The EUR may be supported if this happens, after losing considerable ground during the second quarter against a strong USD.

The ECB’s newly-hawkish rhetoric doesn’t mean convergence with the Federal Reserve’s monetary policy because the central bank is several months behind the US in its reaction to inflation. On top of that, the ECB has a different approach and plans to keep purchasing bonds from the smaller and more vulnerable Southern economies like Greece, which proved to be the Achilles heel during the sovereign debt crisis in Europe between 2010 and 2012.

ECB President Christine Lagarde plans another scheme to limit bond spreads in order to prevent another disastrous round of sovereign debt cuts, but so far has not revealed more information about how it would work.

Other market themes on the near-term interest rate horizon include Japan’s continued dovish stance and the impact of a strong USD on emerging market currencies.

After fighting deflation for nearly two decades, the Bank of Japan appears to have welcomed the relatively moderate growth in its inflation rate but may be turning a blind eye to the risks. It’s true that negative interest rates keep the Yen weak and likely increase the competitiveness of Japan’s exports. But it’s also a fact that the country’s cost of living is on the rise and affecting consumer spending, a key metric of economic growth.

The MSCI emerging markets index headed down after the Federal Reserve started hiking its interest rate guidance in March. The index, which covers a basket of emerging market stocks against the USD, continues to show volatility. Since April, the MSCI EM currency benchmark has also tracked a broad downward trend and volatility.

In summary, the main drivers of the Forex and Stock markets appear likely to continue into the third quarter: monetary tightening, monetary divergence between the Federal Reserve and the Bank of Japan, and a stronger USD pressuring emerging market currencies.

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