• The U.S. economy remains on firm footing; U.S. yields continue to rise; strange things are happening to the U.S. curve; August ISM services PMI came in strong; the Fed releases its Beige Book report; BOC is expected to hike rates 75 bp to 3.25%; Chile delivered a hawkish surprise with a 100 bp hike to 10.75% vs. 75 bp expected
  
• Reports suggest the U.K. is stepping back from a Brexit confrontation with the EU; BOE officials testify to Parliament’s Treasury Committee; BOE tightening expectations have eased slightly; the ECB is expected to hike rates 75 bp tomorrow; Germany reported July IP; Poland is expected to hike rates 25 bp to 6.75%
  
• Japan officials are getting more concerned about the weak yen; there’s really not much that can be done about the weak yen as long as the BOJ maintains its ultra-dovish stance; Australia reported firm Q2 GDP data; China reported soft August trade data
  

The dollar continues to gain. DXY is up for the second straight day and traded at a new cycle high today near 110.694. The euro continues to struggle and traded at a new cycle low near $0.9865 yesterday before recovering to $0.9900 currently. We believe it remains on track to test the September 2002 low near $0.9615. Sterling is nearing the $1.1445 cycle low and remains on track to test the March 2020 low near $1.1410. After that is the December 1985 all-time low near $1.0520. USD/JPY traded at a new high for this move near 144.70 today and we maintain our medium-term target of 147.65, the August 1998 high as we downplay risks of BOJ intervention for now. Indeed, we maintain our strong dollar call as it benefits from both a solid U.S. economic outlook and growing risk-off impulses from Europe.

AMERICAS

The U.S. economy remains on firm footing. The jobs report was solid, as were Chicago and both ISM PMI readings. After a weak Q2 reading of -0.6% SAAR, GDP growth has picked up and the Atlanta Fed’s GDPNow model is currently tracking 2.6% SAAR for Q3. The next update is scheduled for today. What this means is that the Fed is on track to continue hiking rates aggressively. In turn, this supports our ongoing strong dollar call.

U.S. yields continue to rise. The 10-year yield traded near 3.36% today, the highest since mid-June and on track to test the June 14 high near 3.50%. The real 10-year rose to 0.87% yesterday, the highest since January 2019 and nearing the November 2018 high near 1.15%. The 2-year yield traded near 3.52% today, just below the cycle high near 3.55% from last week.

Strange things are happening to the U.S. curve. The 2- to 10-year curve is trading near -14 bp, the least inverted since July 12. Our preferred measure (3-month to 10-year) traded near 45 bp yesterday, the steepest since July 21. It’s all coming from the long end, as the 10-year yield has risen sharply off the 2.51% cycle low from August 2. With Quantitative Tightening (QT) set to accelerate this month, it’s possible that the long end is finally behaving as one would expect, but it’s still too early to throw in the towel on the curve flattening trade as the Fed continues to tighten aggressively. Stay tuned.

August ISM services PMI came in strong. Headline was 56.9 vs. 55.3 expected and 56.7 in July. This was the second straight improvement to the highest reading since April. Employment came in at 50.2 vs. 49.1 in July, while prices paid came in at 71.5 vs. 72.3 in July. ISM manufacturing PMI also came in stronger than expected. We note that S&P Global revised its August services PMI down to 43.7 vs. 44.1 preliminary, adding to the disparity between the two measures. The S&P Global PMI readings have mostly come in on the weak side of ISM in recent months but it seems clear to us that ISM is giving a truer picture of the U.S. economy right now. Today, only July trade data will be released and is expected at -$70.3 bln vs. -$79.6 bln in June.

The Fed releases its Beige Book report. The last Beige Book was released July 13 and the Fed ended up hiking 75 bp at the July 26-27 FOMC meeting. Since then, headline inflation has eased from 9.1% in June to 8.5% in July, while jobs grew a combined 841k in July and August. Survey data suggests price pressures are falling while supply chains are improving. We think this current backdrop will give the Fed cover to hike another 75 bp at the September 20-21 FOMC meeting. Meanwhile, Fed officials will remain hawkish. Barkin, Mester, Brainard, and Barr speak today. Powell speaks tomorrow. Evans, Waller, and George speak Friday. At midnight Friday, the media blackout goes into effect and there will be no Fed speakers until Chair Powell’s post-decision press conference on September 21.

Bank of Canada is expected to hike rates 75 bp to 3.25%. At the last meeting July 13, the bank delivered a hawkish surprise with a 100 bp hike to 2.5% vs. 75 bp expected. Governor Macklem said then that “By front-loading interest rate increases now, we are trying to avoid the need for ever higher interest rates down the road. This argues for getting our policy rate quickly to the top end.” He added that he believes that’s “slightly” above the neutral range, which the central bank estimates between 2-3%. The swaps markets is pricing in 125-150 of tightening over the next 6 months that would see the policy rate peak between 3.75-4.0%. Canada also reports July trade and August Ivey PMI.

Chile central bank delivered a hawkish surprise with a 100 bp hike to 10.75% vs. 75 bp expected. There was one dissent in favor of an even larger 125 bp move. The bank noted that “The next move in rates will depend on the macroeconomic scenario,” they said. “The board will pay special attention to the risk of higher inflation.” The bank releases its quarterly monetary policy today, while August CPI will be reported Thursday with headline expected at 13.8% y/y vs. 13.1% in July. If so, it would be the highest November 1992 and further above the 2-4% target range. The swaps market is pricing in 25 bp of tightening over the next 3 months that would see the policy rate peak near 11.0% but there are clear upside risks after this most recent hike.

EUROPE/MIDDLE EAST/AFRICA

Reports suggest the U.K. is stepping back from a Brexit confrontation with the EU. FT reports that Prime Minister Truss will not activate the emergency Article 16 in the Northern Ireland protocol that would allow the U.K. to make unilateral changes in the treaty. Instead, the U.K. will reportedly request an extension to the grace periods. Irish Foreign Minister Coveney said he doesn’t expect Truss will trigger Article 16, noting “Liz Truss has had the opportunity and has been asked by some to trigger Article 16 before, and she hasn’t done it.” This is welcome news as the last thing the U.K. needs right now is a trade war with its largest trading partner. That said, Brexit is now on the back burner but the matter is in no way resolved.

Bank of England officials testify to Parliament’s Treasury Committee. Governor Bailey said he is happy that a review of the bank’s target has come up, noting that “we can always learn from the experience.” He also said that Russia, not the BOE, is the cause for U.K. recession. Chief Economist Pill said he can’t speculate yet on the bank’s response to the proposed energy cost caps, but added that he would expect the government’s moves to cut inflation. MPC member Mann said forceful front-loaded rate hikes may allow for a pause and reversal later, while M{C member Tenreyro noted that the main impact of the bank’s tightening has yet to be seen. We suspect she meant the impact on inflation, as Tenreyro later noted that demand is already weakening. She also admitted that she is uncertain what policy rate is needed to curb inflation.

BOE tightening expectations have eased slightly. WIRP suggests a bit over 50% odds of a 75 bp hike to 2.5% September 15. Looking ahead the swaps market is pricing in 250 bp of tightening over the next 12 months that would see the policy rate peak near 4.25%, down from 4.5% at the start of this week but up from 4.0% just two weeks ago. The market is likely reacting to the energy price cap plan, and Pill is right to highlight the dilemma facing the BOE. Energy price caps will help limit inflation, which at the margin lessens the need for some amount of tightening . However, the cap is an artificial construct that doesn’t do anything to address the underlying supply-demand imbalance and comes at a fiscal cost.

The European Central Bank is expected to hike rates 75 bp tomorrow. WIRP suggests nearly 65% odds of a 75 bp hike and we believe the bank will meet these expectations. Higher than expected August CPI readings certainly make the case for more aggressive tightening and it seems that more and more officials on the Governing Council are leaning towards this outcome. While the energy crisis adds another wrinkle to the process, we think it is too early yet for it to impact ECB policy right now. New macro forecasts will be released. Of note, the swaps market is pricing in 225 bp of tightening over the next 12 months that would see the deposit rate peak near 2.25%.

Germany reported July IP. It came in at -0.3% m/m vs. -0.6% expected and a revised 0.8% (was 0.4%) in June, while the y/y rate came in at -1.1% vs. -2.1% expected and a revised -0.1% (was -0.5%) in June. Germany remains the weak link in the eurozone and the data are likely to continue weakening as the energy crisis bites. Elsewhere, Italy reported firm July retail sales. Sales rose 1.3% m/m vs. 0.2% expected and -1.1% in June, while the y/y rate came in at 4.2% vs. 1.3% in June.

National Bank of Poland is expected to hike rates 25 bp to 6.75%. However, a handful of analysts look for a larger 50 bp move. At the last meeting July 7, the bank delivered a dovish surprise with a 50 bp hike to 6.5% vs. 75 bp expected. August CPI came in higher than expected at 16.1% y/y vs. 15.6% in July, the highest since October 1996 and further above the 1.5-3.5% target range. As such, we see risks of a hawkish surprise. The swaps market is pricing in 50 bp of tightening over the next 6 months that would see the policy rate peak near 7.0%.

ASIA

Japan officials are getting more concerned about the weak yen. Finance Minister Suzuki said he was concerned about sudden and one-sided moves in the FX market, adding that “We’ll keep watching the markets with a high sense of urgency, and if the moves continue we’ll respond as needed.” Elsewhere, Chief Cabinet Secretary Matsuno said “We’re concerned about the rapid and one-sided moves being seen recently in foreign exchange markets. The government will continue to watch forex market moves with a high sense of urgency, and take necessary responses if this sort of move continues”

There’s really not much that can be done about the weak yen as long as the BOJ maintains its ultra-dovish stance. The upcoming September 21-22 BOJ meeting will offer the bank an opportunity to make a stand against the weak yen but we see no action. Recall that at the July 20-21 meeting, Governor Kuroda said “If you were serious about stopping the weaker yen just with rate increases, you would need significant hikes and they would be very damaging to the economy.” At that time, USD/JPY was trading near 137 but is now trading at new multi-year highs near 144.40. FX intervention without any change in the BOJ’s monetary policy stance would only provide temporary relief. What’s more, this is a strong dollar problem, not a weak yen problem and so again, FX intervention would likely be ineffective.

Australia reported firm Q2 GDP data. Growth came in as expected at 0.9% q/q vs. a revised 0.7% (was 0.8%) in Q1, while the y/y rate came in at 3.6% vs. 3.4% expected and 3.3% in Q1. Strong household consumption was a major factor as it jumped 2.2% q/q and contributed 1.1 percentage points to growth. Net exports added 1.0 percentage points to growth, while inventories subtracted 1.2 percentage points. The RBA’s aggressive tightening has not hit the economy yet, nor has the sudden slowdown in the mainland economy. Both of these headwinds should strengthen in H2 and so we look for growth to slow in the coming quarters. WIRP suggests less than 20% odds of a 50 bp hike at the next RBA meeting October 4, while the swaps market is pricing in 200 bp of tightening over the next 12 months that would see the policy rate peak near 4.35%.

China reported soft August trade data. Exports came in at 7.1% y/y vs. 13.0% expected and 18.0% in July, while imports came in at 0.3% y/y vs. 1.1% expected and 2.3% in July. As one of the major drivers for regional trade and activity, the sharp slowdown in imports is particularly worrisome and reflects a significant slowdown in the economy. With PBOC still in easing mode, USD/CNY is likely to continue climbing. The pair traded at the highest since August 2020 near 6.98 and is on track to test the May 2020 high near 7.1775. Policymakers have taken some modest steps to support the yuan but here too, the impact is likely to be negligible as long as the monetary policy divergence with the U.S. remains in play.