U.S.-Japan interest rate spread widens as UK recession looms

Many institutions predict that the UK will fall into recession later this year. That could leave the pound vulnerable, with energy costs for UK consumers set to rise by 80%, with the average household's annual bill reaching £3,549 ($4,188). A decisive and urgent government intervention is required to respond. Sterling investors also assessed the possible impact of the news.

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At the Jackson Hole meeting, Fed Chairman Powell sent a strong eagle signal: In order to fight inflation, the Fed may continue to raise interest rates and maintain them at a high level for a period of time. Powell also added the Volcker-era case that "historical record strongly warns against premature easing". Subsequently, Rick Rieder, chief investment officer of BlackRock's global fixed income department, quickly released a report saying that the Fed may raise interest rates quickly this year, but next year, the Fed should wait and see for a while. "[Fed Chair Powell's remarks] did not dissuade our belief that the Federal Open Market Committee (FOMC) may raise rates by 75 basis points at its Sept. 21 meeting," Reid wrote in the report.

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Fed inflation remains hot. The latest data showed that the U.S. CPI annual rate of 8.5% in July, although down from a 41-year high of 9.1% in June, is still very far from its 2% target. While it is absolutely necessary for the Fed to control the current high inflation rate, the Fed could over-tighten policy and undermine much of the U.S. economy's recovery from the shock of the pandemic.

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The policy differences between the Federal Reserve and the Bank of Japan will further widen the US-Japan interest rate gap, which may drive the USD/JPY to test a 24-year high of 139.38. Traders expect the U.S. interest rate hike cycle to be higher and longer, and U.S. short-dated bond yields remain elevated, with two-year U.S. Treasury yields holding near two-month highs.

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Mark Cabana, head of rates strategy at Bank of America Securities: Interest rates markets initially thought Powell was hawkish and strong in his promise to restore price stability. However, that view was later retracted, given the limited clear guidance Powell gave. Powell hinted that restrictive policies may be necessary for some time, but he provided limited guidance for the September FOMC meeting, as expected.

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The energy crisis could prompt the UK government to provide more support to households, leading to further rate hikes by the Bank of England. British households may need further government support of up to £65bn to offset a rise in energy bills this winter. Combined with the possible tax cuts if Truss becomes prime minister, the risk of a deep recession will be greatly reduced. We agree with the market that the Bank of England will see a reduced chance of recession as a means of raising its medium-term inflation forecast, and thus may feel the need to raise rates further.

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The euro has fallen sharply against the dollar in 2022, and while factors such as the U.S. economy and Federal Reserve policy are important drivers of the decline, the rising cost of energy supply disruptions has given some of the more pessimistic market forecasters the most confidence. The euro took a breather for much of the week after falling back below dollar parity in intraday trading on Monday, but European gas prices remained high after a prolonged period of sharp gains. It is these costs and the impact they are expected to have on businesses and households that has led some forecasters to believe that the euro's 18-plus-month decline may still have some way to go.