• Markets are still digesting last week’s blockbuster jobs report; Fed tightening expectations continue to adjust; higher U.S. yields continue to support the dollar; Chile reports July CPI and trade data
  
• U.K. households are facing even greater energy bills; despite the gloomy outlook, the BOE is set to continue tightening as inflation spirals ever higher; Czech central bank Governor Michl signaled the end of the tightening cycle, at least for now
  
• Japan reported June current account data; China reported July trade and foreign reserves data
  

The dollar is consolidating its recent gains. DXY is modestly lower and trading near 106.50 currently. The euro remains heavy after a brief move above $1.02 that was quickly reversed, and remains on track to test the July 27 low near $1.0095. Sterling has stabilized after its post-BOE sell-off but remains heavy after a move above $1.21 earlier today failed to trigger any follow-through buying. We believe it is still on track to break below the July 29 low near $1.2065. If weakness continues as we expect, the July 21 low near $1.1890 comes into focus. USD/JPY traded at a new high for this move near 135.60 and is on track to test the July 27 high near 137.45. We maintain our strong dollar call as Fed officials are making it clear that markets misread the Fed’s commitment to lowering inflation. This has been backed up by the stronger than expected data and this trend should continue.

AMERICAS

Markets are still digesting last week’s blockbuster jobs report. Nearly a million jobs were added in the past two months, driving the unemployment down to a new cycle low of 3.5%. More importantly, wages continue to grow nicely and should help support consumption. While a strong labor market does not preclude a recession, it does drive home the point that the Fed will have more confidence to continue tightening policy in order to bring inflation down.

Fed tightening expectations continue to adjust. WIRP is now showing over 75% odds of a 75 bp hike at the September 20-21 FOMC meeting. Looking ahead, the swaps market is now pricing in a 3.75% terminal rate vs. 3.5% at the start of last week. We think this is the correct read and if the market gives the Fed 75 bp next month, the Fed will take it. However, the market is still pricing in a quick turnaround by the Fed to move into an easing cycle in H1 2023. It's pretty clear that the Fed doesn't see it that way and the data bear that out, at least for now. Markets should also reprice these easing expectations in the coming days and weeks.

Higher U.S. yields continue to support the dollar. The 2-year yield traded as high as 3.31% Friday and is trading near 3.21% today, while the 10-year yield traded as high as 2.87% Friday and is trading near 2.80% today. The 2-year differentials with Germany, the U.K., and Japan continue to move higher and that’s dollar-positive. Of note, the gap with Germany has risen to 277 bp, a new high for this move and the highest since May 2019. With the Fed on track to continue tightening aggressively, these differentials should continue to move even higher.

Chile reports July CPI and trade data. Inflation is expected at 13.0% y/y vs. 12.5% in June. If so, it would be the highest since March 1994 and further above the 2-4% target range. At the last policy meeting July 13, the central bank hiked rates 175 bp to 9.75% vs. 150 bp expected. More hikes are likely as the bank noted then that “The board estimates that new increases in the monetary policy rate will be necessary to ensure the convergence of inflation to 3% in two years.” The bank also removed language in its statement about reducing the size of future rate hikes. Next policy meeting is September 6 and another large hike is expected. The swaps market is pricing in 100-125 bp of further tightening over the next 6 months that would see the policy rate peak between 10.75-11.0% but we see some upside risks.

EUROPE/MIDDLE EAST/AFRICA

U.K. households are facing even greater energy bills. U.K. Power Networks, the largest electricity distribution firm, said consumers will face a hit of GBP280 mln due to the failure of several energy companies. The costs of maintaining domestic supply by the failed companies will be passed on to customers, and the company estimates that the accumulated costs through March 31 of this year was approximately GBP280 mln. Regulator Ofgem has agreed with the company that the majority of the coasts will be recovered from customers through higher power tariffs. This will come on top of the expected spike in energy costs this fall from a planned adjustment in regulated prices.

Despite the gloomy outlook, the BOE is set to continue tightening as inflation spirals ever higher. WIRP suggests a 25 bp hike September 15 is fully priced in, with nearly 90% odds of a larger 50 bp move. The swaps market is pricing in 125-150 bp of tightening over the next 6 months that would see the policy rate peak between 3.0-3.25%, up from 2.75% at the start of last week.

Czech central bank Governor Michl signaled the end of the tightening cycle, at least for now. He wrote that the decision to keep rates steady last week will give the bank time to assess the impact of current interest rates on the economy. He reiterated his view that inflation is being driven mainly by external shocks, such as high energy costs. Michl said that the bank believes that falling real income will dampen household demand, while corporate and household borrowing is already slowing. As such, Michl believes that “The current level of interest rates is therefore sufficiently restrictive for now.” Next policy meeting is September 29 and the bank said it will decide then whether to keep rates steady or hike. It sounds like the bank has already made up its mind about future tightening but it’s unclear whether the markets will continue to accept such a dovish view. As we noted last week, a 7% nominal policy when inflation is 17.2% and rising doesn't seem to be restrictive enough.

ASIA

Japan reported June current account data. The adjusted balance came in at JPY838 bln vs. -JPY28 bln expected and JPY8 bln in May. However, the investment flows will be of most interest. Data showed that Japan investors were net sellers of U.S. bonds for the eighth straight month and the -JPY3.72 trln total was the biggest since April 2020. Japan investors were small net buyers (JPY8 bln) of Australian bonds and were net sellers of Canadian bonds (-JPY337 bln) for the fifth straight month. They were small net sellers of Italian bonds (-JPY32 bln) for the second straight month. All in all, the data suggest Japan’s life insurers sold a net JPY1.56 trln in July while pension funds sold a net JPY866 bln, both record highs. This repatriation would help explain the 6.5% drop in USD/JPY from mid-July through early August.

China reported July trade and foreign reserves data over the weekend. Exports came in at 18.0% y/y vs. 14.1% expected and 17.9% in June, while imports came in at 2.3% y/y vs. 4.0% expected and 1.0% in June. As a result, the monthly trade surplus hit a record high $101 bln vs. $89 bln expected. It’s hard to see how export growth can remain robust in H2 with global growth slowing, while imports are likely to remain volatile due to periodic spikes in COVID infections. Elsewhere, foreign reserves rose to $3.1 trln vs. $3.05 trln expected.