Market analysis: US Federal Reserve looks beyond ‘transitory’ softness

A better than expected rise in non-farm payroll jobs supports an outlook for moderate growth ahead. Justin Sullivan / Getty Images / AFP

The solid US jobs report for April should cement a Federal Reserve rate hike in June, with the Fed having already indicated its willingness to look through the “transitory” softness of first quarter economic data. Ordinarily, the US dollar would be benefiting from such news, but against the euro and sterling it is being held back by the uncertainty of elections as well as by the greater uncertainty about Brexit.

Unless something unforeseen happens between now and the June Federal Open Market Committee meeting, it seems likely that the Fed will raise interest rates again following the firm April jobs data reported at the end of last week. The better than expected rise in non-farm payroll jobs of 211,000; the decline in the unemployment rate to 4.4 per cent along with a 0.3 per cent rise in earnings; and a pickup in hours worked support the Fed’s view that the weakness in March was transitory, and support its outlook for moderate growth ahead and the dot-plot forecast for two more interest rate rises this year.

Completing a week that also saw the Trump White House score its first legislative win in Congress over healthcare reform, marking a better start to president Donald Trump’s second 100 days in office, it would be natural to think that the dollar should benefit from such news. To some extent it did with the Japanese yen, Australian dollar and Canadian dollar remaining fragile, although some of this was more to do with big falls in oil prices hurting commodity currencies. However, against the currency majors of the euro and sterling, the dollar finished the week still under pressure as if the jobs figures had not happened at all.

For the euro and sterling, of course, other things have been going on. In Europe the approach of the final round of French elections has seen the euro appreciate as opinion polls have consistently suggested that Emmanuel Macron will win convincingly, especially after mid-week debate that saw his opponent Marine Le Pen falter.

Writing ahead of the vote, a surprise Le Pen victory would certainly cause a sharp jolt across all euro-zone markets, including the euro which would drop very sharply. But even in the event of the expected Macron victory it is becoming harder to imagine how much stronger the euro would be able to rise.

After all, political uncertainty is unlikely to end if Mr Macron wins the presidency, especially if he does not win by as big a margin as the opinion polls suggest. Focus will quickly turn to the June national assembly elections, which are likely to result in a split parliament making it difficult for him to rule effectively. Second, the euro-dollar exchange rate is already trading at a much higher level than that implied by expected interest rates in the euro zone and the US, a situation that is unlikely to persist indefinitely. More likely, interest rate differentials will move further against the euro as the Fed hikes rates while the European Central Bank keeps its interest rates low despite reduced political risk and an improving euro-zone economy.

Sterling has also been buoyed recently by the prospect of a general election in the UK on June 8, which has shored up confidence in the Theresa May-led Conservative government being able to deliver a Brexit outcome that is good for the UK economy. In the process this has caused sterling to go from being the weakest G10 currency this year a few weeks ago to being the strongest currency in the space of just a few days.

However, the “Downing Street dinner-party” events of the last fortnight should serve to remind markets that whatever the election outcome the likelihood is for a very torturous Brexit negotiation process, in which the potential cost to the UK economy from exiting the EU appears to be getting larger by the day, with the EU now claiming a €100 billion settlement charge, up from €50bn just a few months ago. It is unlikely that these negotiations will start properly until after the German elections in September, but the signs are already ominous that the outcome may not be as straightforward as the pound’s current lofty levels suggest.

And with a more hawkish Fed now waiting in the wings, both sterling’s and the euro’s recent rallies might soon be seen as more of a case of having jumped the gun.

Tim Fox is chief economist and head of research at Emirates NBD.

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