- The Fed doves remain vocal; the U.S. economy remains robust; U.S. Treasury began its quarterly refunding; Mexico reports July CPI; Brazil central bank minutes suggest it will continue to cut rates in 50 bp clips
- Italy backtracked a bit on its controversial windfall tax on banks; while the news is welcome, one can’t help but get the sense that the plan was neither well-coordinated nor well thought out; major U.K. think-tank issued some very bearish forecasts
- Japan reported weak July machine tool orders; China reported soft July CPI and PPI data
The euro is leading the way higher for the foreign currencies after Italy backtracked on its bank tax (see below). The euro is trading near $1.0980 but remains on track to test the July low near $1.0835. DXY is trading lower near 102.413 after two straight up days but remains on track to test the July high near 103.572. Sterling is trading lower near $1.2745 and remains on track to test the late June low near $1.2590. USD/JPY is trading flat near 143.30 and remains on track to test the June 30 high near 145. Despite the softish jobs data, we believe the relative fundamental story should continue to move in favor of the greenback. As we expected, the recent FOMC, ECB, and BOJ decisions as well as the ongoing economic data underscore the divergence theme and so further dollar gains seem likely. Tomorrow’s CPI data will be key.
The Fed doves remain vocal. Harker said that “Absent any alarming new data between now and mid-September, I believe we may be at the point where we can be patient and hold rates steady and let the monetary policy actions we have taken do their work.” Thankfully, Barkin was a little more circumspect, noting that “I’m leaning toward waiting until September to decide. We’ll get two labor reports, we’ll get two inflation reports, including one that’s coming Thursday. I don’t see any reason to pre-judge.” There are no Fed speakers scheduled today. WIRP suggests odds of a hike September 20 are around 15% but we think this should be much higher. Those odds top out near 35% November 1 but should move higher if the data remain firm.
The U.S. economy remains robust. The Atlanta Fed’s GDPNow model is currently tracking Q3 growth at 4.1% SAAR vs. 3.9% previously and 2.4% in Q2. Of course, that rate is likely to come down as the data come in but the momentum is undeniable. Next model update comes next Tuesday. With the economy continuing to grow above trend, how do the Fed doves expect inflation to come down? Chair Powell has been saying that while a recession is not necessary to bring inflation down, a period of sub-trend growth is very much necessary. We concur, and believe that the dove’s soft landing scenario remains a fairy tale. Indeed, the ongoing strength of the economy simply means that the Fed will very much have to go higher for longer.
The U.S. Treasury began its quarterly refunding. The total of $103 bln will be sold and it began yesterday with a $42 bln sale of 3-year notes at a yield of 4.398% vs. 4.534% at the previous auction. Indirect bidders took 74.0% vs. 69.4% at the previous auction and the bid to cover ratio came in at 2.90 vs. 2.88 at the previous auction. It continues with a $38 bln sale of 10-year notes today. At the previous auction, indirect bidders took 67.7% and the bid to cover ratio was 2.53. It concludes tomorrow with a $23 bln sale of 30-year bonds. At the previous auction, indirect bidders took 69.0% and the bid to cover ratio was 2.43.
Mexico reports July CPI. Headline is expected at 4.79% y/y vs. 5.06% in June, while core is expected at 6.66% y/y vs. 6.89% in June. If so, headline would be the lowest since March 2021 but still above the 2-4% target range. Banco de Mexico then meets tomorrow and is expected to keep rates steady at 11.25%. At the last meeting June 22, the bank kept rates steady and officials subsequently said that rates would remain steady for 2-3 meetings. That suggests no change at the September 28 meeting either and leaves the November 9 meeting as the earliest we can probably expect to see easing. The swaps market is pricing in no easing over the next three months followed by a cautious 25 bp of easing over the subsequent three months.
Brazil central bank minutes suggest it will continue to cut rates in 50 bp clips. The bank noted that “The Committee judges that there is low probability of an additional intensification in the pace of adjustment.” It added that a faster pace of rate cuts would require “substantial” improvements in the inflation dynamics, including a “sharp” widening of the output gap and more benign service sector inflation. Next meeting is September 20 and another 50 bp cut to 12.75% is expected. The swaps market is pricing in 100 bp of easing over the next three months followed by another 125 bp of easing over the subsequent three months. If so, we would expect downward pressure on the real to persist.
Italy backtracked a bit on its controversial windfall tax on banks. Italy’s Finance Ministry said that the tax won’t exceed 0.1% of a bank’s assets, adding that banks that have already increased their interest rates offered to depositors “will not have a significant impact as a consequence of the rule.” It wasn’t clear whether those assets were global or those in Italy. Eurozone bank stocks have recovered about half of yesterday’s losses, with Italian banks leading the way.
While the news is welcome, one can’t help but get the sense that the plan was neither well-coordinated nor well thought out. Reports suggest Finance Minister Giorgetti was forced into damage control yesterday and was not even present at the press conference where Deputy Prime Minister Salvini announced the plan. Investors should also be wary of this sort of event risk going forward, not just in Italy but in other eurozone countries that may be feeling the fiscal pinch. While the euro has seen a bit of a relief rally today, we would fade this bounce.
Market expectations for ECB policy remain subdued. WIRP suggest odds of a 25 bp hike stand near 35% September 14, rise to 55% October 26 and top out near 65% December 14. These odds will rise and fall with the data but Madame Lagarde clearly accentuated the negative last week and that’s what markets should focus on. What’s very interesting to us is that the ECB may stop hiking before the Fed does and we don't think the markets have priced this risk in yet.
Major U.K. think-tank issued some very bearish forecasts. The National Institute of Economic and Social Research (NIESR) warned that the U.K. economy is headed for five years of subpar economic growth, with GDP unlikely to return to pre-pandemic levels before 2024. Think tank official warned that “The triple supply shocks of Brexit, Covid and the Russian invasion of Ukraine, together with the monetary tightening that has been necessary to bring inflation down, have badly affected the U.K. economy.” It forecasts inflation of 5.2% at end-2023 and 3.9% at end-2024. Looking further ahead, NIESR sees inflation averaging 2.3% in 2025 and slightly more in 2026.
Bank of England expectations remain subdued after last week’s 25 bp hike. WIRP suggests 85% odds of a 25 bp hike September 21, while a 25 bp hike December 14 is largely priced in with virtually no odds of a third hike after that. This would see the bank rate peak near 5.75% vs. 6.5% at the start of last month. However, the swaps market sees the rate staying at 5.75% over the next twelve months before rate cuts begin in the subsequent twelve months. Indeed, Governor Bailey recently said it was “far too soon to speculate on when we might see a cut.”
Japan reported weak July machine tool orders. Orders came in at -19.8% y/y vs. -21.1% in May and have contracted y/y for seven straight months and nine of the past ten. What’s worrisome is that domestic orders are still contracting faster than foreign orders. We expected slowing global growth to weigh on the external sector but there are growing signs that domestic activity is also slowing. No wonder the BOJ remains so dovish.
China reported soft July CPI and PPI data. CPI came in at -0.3% y/y vs. -0.4% expected and 0.0% in June, while PPI came in at -4.4% y/y vs. -4.0% expected and -5.4% in June. China has entered deflation for the first time since it briefly did from November 2020-February 2021. Given the worsening economic backdrop, there is a big risk that this period of deflation will last much longer.