Data last week confirmed our view that concerns about a U.S. recession are overdone; U.S. yields are moving higher as a result; the Fed is likely to remain on its aggressive tightening path
U.K. Prime Minister Johnson will face a no confidence vote tonight; reports suggest the ECB will firm up plans for a new bond-buying program this week.
The BOJ shows no signs of pivoting from its current ultra-loose policies; Caixin reported its May services and composite PMIs for China; Thailand reported high May CPI
The dollar is down modestly as the new week begins. DXY remains stuck near 102. The euro feels heavy near $1.0725 as it remains unable to mount a test of $1.08 despite market expectations for a more hawkish ECB. The weakening trend in the yen has reasserted itself as USD/JPY is trading near 131 and is approaching the May cycle high near 131.35. We maintain our long-standing target of the January 2002 high near 135.15. Sterling is outperforming today despite the planned no confidence vote but is still having trouble breaking back above $1.26. We look for renewed underperformance from rising political and economic risks that eventually pushes the EUR/GBP cross higher. We still view this recent move lower in the dollar as a correction within the longer-term dollar rally but acknowledge that further gains will be slow until the market pessimism on the U.S. economic outlook improves. We need to see some further strength in the data.
Data last week confirmed our view that concerns about a U.S. recession are overdone. Yes, the economy is slowing, but that is exactly what the Fed wants. Job growth and PMI readings are all slowing from rather lofty levels seen throughout 2021. Consumption remains surprisingly resilient but at some point, it too will slow. The million dollar questions remains whether the Fed can engineer a soft landing. That remains to be seen, but all indications are that a recession is unlikely over the next 12 months.
U.S. yields are moving higher as a result. The 10-year yield traded as high as 2.99% Friday, up from the previous week’s low near 2.70% but still below the May 9 peak near 3.20%. It is currently near 2.95%. Elsewhere, the 2-year yield traded as high as 2.69% Friday, up from the previous week’s low near 2.44% but still well below the May 4 peak near 2.85%. It is currently near 2.68%. The 2-year differential with Germany has fallen to 200 bp, the lowest since the end of February, while the gap with Japan has risen back to 274 bp, just shy of the May 3 high near 283 bp. Much of this divergence hinges on the underlying relative monetary policy divergences as the ECB pivots more hawkish and the BOJ remains ultra-dovish. However, we believe the Fed will out-hawk them all and so the dollar uptrend should remain intact.
The Fed is likely to remain on its aggressive tightening path. Ahead of the weekend, Daly said that she supports 50 bp hikes in June and July and added that “I’m going to come into that September meeting and if I don’t see compelling evidence, then I could easily be a 50 bp in that meeting as well. There’s no reason we have to make that decision today, but my starting point will be do we need to do another 50 or not.” Last week, Bullard made a similar pitch and we believe this stance represents consensus. Yes, there are several FOMC members that appear more non-committal about 50 bp in September but we think they are in the minority. Due to the media blackout, there are no Fed speakers this week.
U.K. Prime Minister Johnson will face a no confidence vote tonight. Press reports that the threshold of 54 letters from Tory MPs needed to trigger the vote has been met. Johnson reiterated that he has no intention of resigning and it’s not clear yet if the rebels have secured the simple majority of Tory MPs (180) needed to remove him. If Johnson wins, he cannot face another confidence vote for a year. Tory backbenchers have seen popular support for their party plunge on surging inflation as well as so-called Partygate. Sterling is strangely bid today despite this news but we expect rising political and economic uncertainty to eventually take a toll on U.K. assets.
Reports suggest the ECB will firm up plans for a new bond-buying program this week. This has been previously reported back in April but the latest update is that many members of the Governing Council will support its creation just as the bank is widely expected to announce the end of APP at this Thursday’s meeting. The new program is meant to help limit any unwanted rise in bond yields. Strangely enough, the ECB already has such a program; it’s called APP. Perhaps the new program will be more flexible, like the old PEPP. Either way, it’s clear that ECB policymakers are well aware of the potential risks as it undertakes its first tightening cycle in over a decade. Peripheral spreads have been climbing all year and are likely to continue climbing as the ECB pivots more hawkish.
The Bank of Japan shows no signs of pivoting from its current ultra-loose policies. Governor Kuroda acknowledged some progress is being made toward the 2% inflation target. Regarding rising inflation expectations, Kuroda said that “This can be regarded as an important change from the perspective of aiming to achieve sustained inflation.” However, he added that with the economy still recovering from the pandemic, the bank must continue with monetary stimulus. Looking further ahead, senior LDP official Shouji Nishida said that Prime Minister Kishida is likely to want the BOJ to maintain its current policy stance even under the next Governor. Our base case remains that current policy settings will be maintained through the end of Kuroda’s term next spring and that his successor will begin the process of removing accommodation. Given Nishida’s statement, it will be even more important to see who Kishida picks as the next Governor.
Caixin reported its May services and composite PMIs for China. Services came in at 41.4 vs. 46.0 expected and 36.2 in April, which dragged the composite higher to 42.2 vs. 37.2 in April. All three Caixin measures are lagging the official readings and the gap between the two data sets has widened considerably over the course of this year. While we expect all the readings to continue rising as movement restrictions are lifted, the huge bounce in the official readings were difficult to justify and we feel that the Caixin readings are probably more accurate. That said, policymakers will remain focused on boosting growth and so further stimulus is likely.
Thailand reported high May CPI. Headline jumped 7.10% y/y vs. 5.85% expected and 4.65% in April, while core rose 2.28% y/y vs. 2.20% expected and 2.00% in April. Headline was the highest since July 2008 and further above the 1-3% target range. Bank of Thailand meets Wednesday and is expected to keep rates steady at 0.50%. However, a couple of analysts polled by Bloomberg look for liftoff with a 25 bp hike to 0.75%. Given the CPI readings, the risks of a hawkish surprise have risen. The Bank of Thailand delivered a dovish hold at the last meeting March 30, with Assistant Governor Piti saying “It’s not worth weighing on the economy to bring inflation back within the target. We don’t want to use a tool that has wide impact now to deal with short-term problem.” The swaps market sees liftoff over the next 6 months but the bank may not be able to wait that long. If it keeps rates steady this week, we believe a hike becomes very likely at the next meeting August 10.