The U.S. rates market continues to price in doom and gloom; regional Fed manufacturing surveys for July have been mixed; Mexico reports mid-July CPI
The ECB delivered a hawkish surprise; it also announced the creation of the so-called Transmission Protection Instrument (TPI); market sentiment waned as Madame Lagarde conducted her press conference; Italian political uncertainty has risen; it’s not clear that widening spreads triggered by a political crisis in Italy would fall under TPI; preliminary eurozone July PMI readings came in weak; U.K. data came in slightly firmer than expected; Russia delivered a dovish surprise; South Africa delivered a hawkish surprise
Japan reported June national CPI data; Japan and Australia reported weak preliminary July PMI readings

The dollar is getting more traction as economic data weaken around the world. DXY is trading back above 107. Despite the ECB’s hawkish surprise yesterday, the euro rally ran out of steam near $1.0280 and is currently trading near $1.0165 due to dovish ECB comments and weak eurozone PMI readings (see below). The weakening trend in the yen has stalled again despite the dovish hold from the BOJ, with USD/JPY trading back near 137 after trading as high as 138.90 yesterday. The sterling rally ran out of steam as it was unable to trade much above $1.20 after several tries this week. It is trading near $1.1950 but is outperforming the euro after U.K. data came in surprisingly firm. When all is said and done, we believe the U.S. economy will prove to be more resilient than the rest of the world and so we look for continued dollar gains. Weak PMI readings out of Asia and Europe support our view, at least for now.

AMERICAS

The U.S. rates market continues to price in doom and gloom. The 10-year yield is trading near 2.82%, the lowest since July 6 and nearing that day’s low near 2.74%, while the 2-year yield is trading near 3.04%. This has led the 2- to 10-yaer curve to fall to a cycle low -22 bp. Faithful readers know that we prefer to look at the 3-month to 10-year curve but that too is moving in a worrisome manner. At 40 bp, it is the flattest since March 2020 and is moving closer and closer to inversion. The speed of flattening has been nothing short of astounding, as it stood at 139 bp at the start of July and was 185 bp in mid-June. A 75 bp hike is fully priced in for next week’s meeting, with nearly 15% odds of a 100 bp move. Another 75 bp hike September 21 is no longer priced in, with a 50 bp move favored then. A 25 bp hike is priced in for November 2 but after that, another 25 bp hike is only partially priced in. The swaps market paints a similar picture, with 175 of tightening priced in over the next 6 months that would see the policy rate peak near 3.5%. Then, an easing cycle is priced in for the subsequent 6 months.

Regional Fed manufacturing surveys for July have been mixed. Philly Fed came in yesterday at -12.3 vs. 0.8 expected and -3.3 in June. Last week, the Empire survey came in at 11.1 vs. -1.2 in June. S&P Global reports its preliminary July PMI readings today. Manufacturing is expected at 52.0 vs. 52.7 in June, while services is expected to remain steady at 52.7 and the composite PMI is expected at 52.4 vs. 52.3 in June. However, given the weak PMI readings already seen for most other nations, there are clearly downside risks for the U.S.

Mexico reports mid-July CPI. Headline is expected at 8.12% y/y vs. 7.88% in mid-June. If so, it would be the highest since January 2001. Banco de Mexico hiked rates 75 bp to 7.75% at the last meeting June 23 and said flagged further large-scale hikes. Minutes from that meeting show that most board members were willing to consider further 75 bp hikes. Next policy meeting is August 11 and another 75 bp hike to 8.5% is expected. Swaps market is pricing in 200 bp of tightening over the next 6 months that would see the policy rate peak near 9.75%.

EUROPE/MIDDLE EAST/AFRICA

The European Central Bank delivered a hawkish surprise. All policy rates were hiked 50 bp, which took the deposit rate up to 0%. WIRP suggests 50 bp hikes are now pretty much priced in for the next meetings September 8 and October 27, followed by a 25 bp hike December 15 would see the deposit rate near 1.25% at year-end. Looking ahead, the swaps market is now pricing in 150 bp of tightening over the next 24 months that would see the deposit rate peak near 1.5%, with small odds of another 25 bp hike thereafter. Updated macro forecasts won’t be released until the September meeting. It’s worth noting that the anonymous post-decision leaks were likely made by the doves this time and not the hawks, as reports suggest ECB officials initially preferred a 25 bp hike before pivoting to 50 bp.

The bank also announced the creation of the so-called Transmission Protection Instrument (TPI). It is meant to ensure effective transmission of monetary policy and counter unwarranted, disorderly market dynamics. The ECB added that the scale of TPI purchases will depend on the severity of the risks facing policy transmission and that there are no restrictions on the size of the purchases. There will be four criteria for TPI: compliance with the EU fiscal framework, no severe macro imbalances, sustainable public finances, and “sound and sustainable” macro policies. TPI will be activated after a comprehensive assessment of market indicators, an evaluation of eligibility, and a judgment that purchases under TPI is proportionate to achieving the ECB’s primary policy objective. TPI purchases will be stopped if there’s a durable improvement in transmission or the ECB decides that persistent tensions are due to country fundamentals.

Yet market sentiment waned as Madame Lagarde conducted her press conference. It became clear that many details of TPI remain murky as the ECB did not reveal what might trigger the bond-buying. Lagarde went so far as to say that the ECB would rather not use TPI. The impact of the 50 bp hike was also diluted when she said that while the ECB is accelerating its pace of tightening now, it is not changing the ultimate point of arrival for rates, or what we like to call the terminal rate. Lagarde said further normalization of policy would continue at the next meetings but added that “We are much more flexible, in that we are not offering forward guidance of any kind.” Today, Kazimir said that the next hike in September may be 25 or 50 bp. Coming from one of the most vocal hawks on the GC, the comment was noteworthy and adds to the confusing ECB outlook.

Italian political uncertainty has risen. President Mattarella accepted Prime Minister Draghi’s resignation, dissolved parliament, and scheduled snap elections for September 25. Mattarella called on all parties to remain engaged, stressing that “The time we live in does not allow us to pause in the crucial government action. We need to contain the impact of Russia’s war in Ukraine.” The most recent poll taken after Draghi resigned show the Brothers of Italy and the center-left Democratic Party are the likely front-runners with support near 24% and 22%, respectively. The League, Five Star, and Forza Italia are next with 14%, 11%, and 7% support, respectively. The Brothers of Italy has seen its support nearly trebled over the past three years and if it were to lead the next government, its leader Meloni would become the next Prime Minister. We are not very confident that an incoming government will be able to agree on the economic reforms needed to unlock EUR200 bln in EU aid.

It’s not clear that widening spreads triggered by a political crisis in Italy would fall under TPI. Italian spreads to Germany have risen to 230 bp, the highest since mid-June and likely to test that month’s high near 242 bp. If the market decides (as we expect) to test the ECB commitment to use TPI, then this spread is likely to move significantly higher. Of note, Italy is now trading at a wider spread to Germany than Greece.

Preliminary eurozone July PMI readings came in weak. Headline manufacturing came in at 49.6 vs. 51.0 expected and 52.1 in June, services came in at 50.6 vs. 52.0 expected and 53.0 in June, and the composite PMI came in at 49.4 vs. 51.0 expected and 52.0 in June. This was the lowest composite reading since February 2021 and supports our view that the eurozone economic outlook was already deteriorating sharply even before the ECB started to tighten policy. It will only get worse, especially given the very real threat of natural gas shortages this fall and winter. Looking at the country breakdown, the German composite came in at 48.0 vs. 50.2 expected and 51.3 in June and the French composite came in at 50.6 vs. 51.1 expected and 52.5 in June. Italy and Spain will be reported with the final PMI readings out in early August. Germany and Italy are most dependent on Russian energy and so stand to weaken the most in the coming months.

The U.K. data came in slightly firmer than expected. June retail sales were reported, with headline coming in at -0.1% m/m vs. -0.2% expected and a revised -0.8% (was -0.5%) in May. Sales ex-auto fuel came in at 0.4% m/m vs. -0.4% expected and a revised -1.0% (was -0.7%) in May. Elsewhere, preliminary July PMI readings were reported. Manufacturing came in at 52.2 vs. 52.0 expected and 52.8 in June, services came in at 53.3 vs. 53.0 expected and 54.3 in June, and the composite PMI came in at 52.8 vs. 52.4 expected and 53.7 in June. While the composite reading is the lowest since February 2021, it remains above the 50 boom/bust level. That’s more than we can say for the eurozone and so the U.K. is a surprise outperformer, at least for now. We know greater headwinds are building this fall as energy prices will be adjusted significantly higher.

Bank of England expectations remain subdued. WIRP suggests a 50 bp hike move at the August 4 meeting is now only around 75% priced in; at the start of this week, it was fully priced in. Similarly, 50 bp hikes are no longer fully priced in for the subsequent meetings September 15 and November 3, though a 25 bp hike December 15 remains fully priced in. Looking ahead, the swaps market is still pricing in 175 bp of tightening over the next 6 months that would see the policy rate peak near 3.0%.

Russia central bank delivered a dovish surprise. It cut rates 150 bp to 8.0% vs. 50 bp expected. However, markets were split as an even greater number of analysts saw cuts of 75 and 100 bp. The bank said it will consider further cuts in H2 as it lowered its end-2022 inflation forecast to 12-15% vs. 14-17% previously. The bank also raised its 2022 GDP forecast to 4-6% contraction vs. 8-10% previously. It noted that shorter-term disinflationary risks had grown but that inflationary risks remain considerable. Headline inflation decelerated for the second straight month in June to 15.9% y/y, the lowest since February but still well above the 4% target. Next policy meeting is September 16 and another cut then seems likely.

South African Reserve Bank delivered a hawkish surprise yesterday. It hiked rates 75 bp to 5.5% vs. 50 bp expected, though nearly a third of the analysts polled by Bloomberg looked for the larger move. The vote was 3-1-1, with one dissent in favor of a 50 bp hike and one in favor of a 100 bp hike. Its model now sees the policy rate at 5.61% by year-end vs. 5.3% previously, at 6.45% by end-2023 vs. 6.21% previously, and at 6.78% by end-2024 vs. 6.74% previously. Governor Kganyago said that “Our assessment now is that this inflation risk is no longer transitory, but that there is persistence that is emerging.” He added that the bank is concerned about widespread wage settlements that are consistently above inflation expectations that could prompt a wage-price spiral.

ASIA

Japan reported June national CPI data. As expected, headline fell a tick to 2.4% y/y while core (ex-fresh food) picked up a tick to 2.2% y/y. Core ex-energy picked up to 1.0% y/y vs. 0.9% expected and 0.8% in May. The readings appear to be consistent with the updated BOJ forecasts, which in turn imply little urgency to tighten policy. Simply put, the dynamics in Japan totally warrant the BOJ maintaining its ultra-loose policy for the foreseeable future; inflation is stabilizing even as the economy is slowing (see below). As Governor Kuroda stressed yesterday, “Right now, we need to continue to tenaciously pursue monetary easing.”

Weak preliminary July PMI readings were also reported. Manufacturing came in at 52.2 vs. 52.7 in June, services came in at 51.2 vs. 54.0 in June, and the composite PMI came in at 50.6 vs. 53.0 in June. This was the lowest reading for the composite PMI since March and certainly adds to global recession risks. Again, recent Japan data will be seen as vindication by the BOJ in terms of its loose policy stance. The swaps market is basically pricing in steady policy for the next 36 months, with very small odds of liftoff seen towards the end of that period.

Australia reported weak preliminary July PMI readings. Manufacturing came in at 55.7 vs. 56.2 in June, services came in at 50.4 vs. 52.6 in June, and the composite PMI came in at 50.6 vs. 52.6 in June. This was the lowest reading for the composite PMI since January and also adds to global recession risks. For Australia, the combination of tighter monetary policy and sharply slower growth in mainland China will continue to weigh on the economy. WIRP suggests 50 bp hikes August 2 and September 6 are fully price in, but are not fully priced in for October 4 and November 1. The swaps market is pricing in 225 bp of tightening over the next 12 months that would see the policy rate peak near 3.60%, down from nearly 4.5% at the start of this month. If the economy continues to weaken, markets will have to reassess this expected terminal rate.