Euro Sinks as Recession Risks Intensify

July 24, 2023
  • The relative story continues to favor the dollar; S&P Global preliminary PMIs will be the highlight; Chicago Fed National Activity Index for June will be important; Mexico reports mid-July CPI
  • The eurozone and U.K. reported soft preliminary July PMIs; ECB and BOE tightening expectations have fallen; Spain is looking at a hung Parliament after weekend elections; Bank of Israel releases its minutes
  • Reports suggest the BOJ will raise its FY23 core inflation forecast to 2.5% vs. 1.8% currently; Japan reported preliminary July PMIs and June department store sales; Australia reported weak preliminary July PMIs; China policymakers pledged to support the nation’s property sector

The dollar continues to climb as the divergence theme carries over into the new week. Data today underscore weakness in the eurozone and the U.K. that has impacted central bank tightening expectations (see below). DXY is trading higher for the fifth straight day near 101.23. The next key retracement levels from the July swoon come in near 101.575 (50%) and 102.045 (62%). The euro is the worst performer today and trading lower near $1.1085 while sterling is holding up relatively better but still trading lower near $1.2835. The yen is outperforming as its PMI readings bucked the weakening trend this month. As a result, USD/JPY is trading lower near 141.20 after trading Friday at the highest since July 10 near 142. A break above 142.10 is needed to set up a test of the June 30 high near 145.05 and we believe a hold from the BOJ this Friday will trigger a move higher in this pair. We had been frustrated with recent dollar weakness but the relative fundamental story seems to be shifting back in favor of the greenback (see below). Cracks are widening in the rest of the world and markets seem to be finally taking note. Further dollar gains thus seem likely after this recent period of consolidation.


The relative story continues to favor the dollar. As the new week gets under way, the dollar is once again benefiting from growing divergences. Those divergences are first seen in the economic outlook and this divergence then spreads to monetary policies. Today, July PMI readings from the eurozone, U.K., and Australis all showed significant deterioration, with many economies clearly tipping into recession. Contrast that with the U.S., where the economy and labor market remain robust and the Fed is widely expected to deliver a hawkish message along with a 25 bp hike this week. On the other hand, the ECB is likely to give a more nuanced message while the BOJ is likely to remain the outlier and keep policy on hold. The dollar rebound should continue this week as economic and monetary policy divergences continue to widen and 2-yaer differentials move further in the dollar’s favor. Q2 GDP data out later this week is likely to show the U.S. growing near trend even as the eurozone flirts with stagnation and recession. Stay tuned.

S&P Global preliminary PMIs will be the highlight. Manufacturing is expected at 46.2 vs. 46.3 in June, services is expected at 54.0 vs. 54.4 in June, and composite is expected at 53.0 vs. 53.2 in June. We see some downside risks given weakness seen elsewhere but the U.S. economy remains head and shoulders above the rest of the world. Period.

Chicago Fed National Activity Index for June will be important. Headline is expected -0.16 vs. -0.15 in May. If so, the 3-month moving average would rise to -0.06 vs. -0.14 and would be the highest since October. Recall that when that 3-month average moves below -0.7, that signals imminent recession and so we are still well above that threshold. This series has taken on greater significance given that the 3-month to 10-year curve remains deeply inverted. The continued resilience in the economy is noteworthy and suggests the Fed still has more work to do in getting to the desired sub-trend growth. Indeed, Q2 GDP will be reported Thursday and expected to come in at 1.8% SAAR vs. 2.0% in Q1. The Atlanta Fed’s GDPNow model is tracking Q2 near 2.4% SAAR and so we see some upside risks. On Friday, the Atlanta Fed releases its first estimate for Q3 GDP growth and will be closely watched for any signs of slowing.

Mexico reports mid-July CPI. Headline is expected at 4.77% y/y vs. 4.93% previously, while core is expected at 6.73% y/y vs. 6.86% previously. If so, headline would be the lowest since March 2021 but still above the 2-4% target range. At the last policy meeting June 22, Banco de Mexico kept rates steady at 11.25% and reiterated that “To achieve the orderly and sustained convergence of inflation to its 3% target, the board considers that it will be necessary to keep the interest rate at its current level for a prolonged period.” Next meeting is August 10 and no change is expected then. The market is pricing in some odds of a cut at the September 28 meeting but we believe November 9 is more likely. Looking ahead, the swaps market is pricing in only 50 bp of total easing over the next six months.


The eurozone reported soft preliminary July PMIs. Headline manufacturing came in at 42.7 vs. 43.5 expected and 43.4 in June, services came in at 51.1 vs. 51.6 expected and 52.0 in June, and composite came in at 48.9 vs. 49.6 expected and 49.9 in June. This was the lowest composite reading since November and is likely to fall further. Looking at the country breakdown, the German composite came in at 48.3 vs. 49.8 expected and 50.6 in June and the French composite came in at 46.6 vs. 47.7 expected and 47.2 in June. Italy and Spain won’t be reported until final PMIs come out next week. However, as things stand, the composite PMIs of Germany, France, and Italy have all dropped below 50 and it’s only a matter of time before Spain does too.

ECB tightening expectations have fallen. A 25 bp hike this week remains largely priced in but the odds of another 25 bp hike stand near 55% September 14, rise to 70% October 26, and top out near 75% December 14. The messaging at this week’s meeting will be key. Given the weakening economic outlook, even leading hawks Knot and Nagel signaled last week that they were not committed to a September hike and so the usual hawk vs. dove dynamics appear to have shifted back in the doves’ favor. As a result, we expect the ECB to send a conditionally hawkish message that is much more data-dependent than the one it gave in June. Updated macro forecasts will come at the September meeting.

Spain is looking at a hung Parliament after weekend elections. The Socialists rode a late surge to win a projected 172 seats with its allies vs. 170 for the right-wing bloc. A majority of 176 seats are needed to form a government. Both parties claimed victory but most expect another election later this year. Much will depend on what the separatist party Junts per Catalunya and its seven seats does. If it abstains from the vote of confidence, Socialist Prime Minister Sanchez would be able to cling to power. While a period of gridlock is possible until the political landscape stabilizes, the markets are for now giving Spain the benefit of the doubt as its 10-year spread to German remains relatively tight at 103 bp.

The U.K. also reported soft preliminary July PMIs. Manufacturing came in at 45.0 vs. 46.0 expected and 46.5 in June, services came in at 51.5 vs. 53.0 expected and 53.7 in June, and composite came in at 50.7 vs. 52.3 expected and 52.8 in June. Construction PMI will be reported next with the final readings. This was the lowest composite reading since January and is now flirting with the key 50 boom/bust level. With inflation remaining stubbornly high and the BOE still hiking rates, it’s only a matter of time before the composite falls below 50 and the economy slips into recession.

BOE tightening expectations continue to fall. WIRP suggests odds of a 50 bp hike August 3 have fallen to 35% after being largely priced in at the start of last week. Looking ahead, 25 bp hikes September 21 and November 2 are priced in but the odds of a fourth hike top out near 35% in February. This lower expected rate path would see the bank rate peak near 5.75% vs. 6.25% at the start of last week and 6.5% at the start of the week before that. This is a huge downward adjustment that is taking a toll on sterling.

Bank of Israel releases its minutes. At the July 10 meeting, the bank kept rates steady at 4.75% and was the first hold since it started the tightening cycle in April 2022 with a 25 bp hike to 0.35%. However, Governor Yaron warned that “We are in an environment of great uncertainty, and there are several upside risks to inflation pressures. It is certainly possible that we will need to increase the interest rate going forward, if we see evidence that the inflation environment is not moderating at a suitable pace.” The shekel has come under some pressure in recent days as political risks rise. The Knesset is scheduled to vote on the controversial judicial reforms Monday even as popular protests intensify. Adding to the uncertainty, Prime Minister Netanyahu had a pacemaker installed over the weekend.


Reports suggest the Bank of Japan will raise its FY23 core inflation forecast to 2.5% vs. 1.8% currently. However, as per previous reports, revisions to the FY24 and FY25 forecasts will be largely unchanged. This outlook would seem to justify steady policy and the Bank of Japan meeting will end Friday with an expected hold. Other reports suggest, contrary to market speculation, that the bank will not tweak its Yield Curve Control. We concur and see an October tweak as more likely. Liftoff is not likely until 2024. While the BOJ always has the capacity to surprise markets, we truly believe that policymakers remain very concerned about removing accommodation too soon.

Japan reported solid preliminary July PMIs and June department store sales. Manufacturing fell to 49.4 vs. 49.8 in June, while services fell a tick to 53.9. Yet the composite somehow remained steady at 52.1. Elsewhere, department store sales came in at 7.0% y/y vs. 6.3% in May and reversed the slowing in trend that began in March. Still, Japan’s economy is holding up relatively well compared to others in the region.

Indeed, Australia reported weak preliminary July PMIs. Manufacturing rose to 49.6 vs. 48.2 in June, but services fell to 48.0 vs. 50.3 in June. As a result, the composite fell for the third straight month to 48.3 vs. 50.1 in June. This is the lowest since December but with China slowing and the RBA tightening, we see further downside ahead.

RBA expectations remain subdued. WIRP suggests 45% odds of a hike August 1, rising to 65% September 5 and 85% for October 3. After the first hike becomes fully priced in November 7, the odds of a second hike rise to 35% December 5 and top out at nearly 60% in early 2024. Here too, it will all depend on the data. CPI data this Wednesday will be closely watched.

China policymakers pledged to support the nation’s property sector. The Communist Party’s 24-member Politburo also called for actively boosting domestic demand and to address risks stemming from the growing debt overhang. And yet like all the recent policy pronouncements, this one was also short on details. Stay tuned.

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