The recovery in U.S. yields has been halted by the return of risk-off impulses; Fed tightening expectations have fallen a bit; Powell delivers his semi-annual testimony before the Senate; May Chicago Fed National Activity Index came in weak; housing data will remain in focus as weakness in that sector persists; Canada reports May CPI data
The ECB seems to be following a policy of strategic ambiguity regarding its planned crisis tool; Italy is back in the headlines due to rising political risks; U.K. reported May CPI data; South Africa reported May CPI; Czech National Bank is expected to hike rates 100 bp to 6.75%.
The BOJ minutes are worth discussing; Prime Minister Kishida is coming under fire for high inflation as campaigning for Upper House elections begins
The dollar is firm as risk-off impulses return. Global equity markets are down, as are global bond yields due to rising concerns about global recession. DXY is trading back above 104.50 but has yet to mount a serious challenge to the new cycle high from last week near 105.788. The euro traded below $1.05 but losses have been limited by ECB hawkishness and optimism regarding the new crisis tool. The weakening trend in the yen continues, with USD/JPY making a marginal new high for this cycle 136.70 today before risk-off sentiment has led to some JPY and CHF outperformance. As risk-off impulses fade and BOJ dovishness is maintained, we believe the pair will eventually test the August 1998 high near 147.65. Sterling has seen some support due to recent BOE hawkishness but is having trouble sustaining a move above $1.23. For now, the so-called dollar smile seems to be in play and so we look for continued dollar gains.
AMERICAS
The recovery in U.S. yields has been halted by the return of risk-off impulses. The 10-year yield is trading near 3.22%, slightly above last Thursday’s low near 3.18% and still well below last week’s peak near 3.50%. Elsewhere, the 2-year yield is trading near 3.12%, slightly above last Thursday’s low near 3.08% and still well below last week’s peak near 3.45%. While we acknowledge that this month’s run up in yields was getting a bit overdone in terms of the pace, we continue to believe that the direction remains intact once this bout of risk-off sentiment passes. As it is, the dollar continues to gain during these risk-off episodes but when all is said and done, we believe monetary policy divergences remain the dominant driver for FX. As the U.S. economic outlook remains the strongest and the Fed the most hawkish relative to its DM peers, the dollar uptrend should remain intact.
Fed tightening expectations have fallen a bit. WIRP suggests a 75 bp hike at the next meeting July 27 is 80% priced in, while 50 bp hikes at the subsequent meetings September 21 and November 2 are pretty much priced in. Looking ahead, however, the swaps market is pricing in 200 bp of tightening over the next 12 months that would see the policy rate peak near 3.75%, down from the cycle peak near 4.75% last week but up from 3.0% at the start of this month. Recession fears are picking up and impacting Fed expectations. While we acknowledge that recession risks have risen, we do not see one coming in the next 12 months.
Powell delivers his semi-annual testimony before the Senate. This will be followed by his appearance before the House tomorrow. He will no doubt come under heavy criticism for allowing inflation to move so high. Powell will of course defend his (and the Fed’s ) record forcefully. Of note, the Fed is required to submit its Monetary Policy Report to Congress to support Powell’s testimony. It was posted on the Fed’s website here last Friday. The key passage in the introduction reads “The Committee is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee's commitment to restoring price stability—which is necessary for sustaining a strong labor market—is unconditional.” Barkin, Evans, and Harker also speak today.
May Chicago Fed National Activity Index came in weak. The headline came in at 0.01 vs. 0.47 expected and a revised 0.40 (was 0.47) in April. This led the 3-month moving average to fall to 0.20 vs. a revised 0.40 in April, the lowest since June 2021 but still nearly a full point above the -0.7 threshold that signals imminent recession. Obviously, the slowdown is concerning and we need to keep an eye on this data series, as well as the U.S. yield curve.
Housing data will remain in focus as weakness in that sector persists. Yesterday, May existing home sales came in at -3.4% m/m vs. -3.7% expected and -2.4% in April. This dragged the y/y rate down to -8.6% vs. -6.0% in April while the supply of existing homes for sale rose to 2.6 months, the highest since last August. May new home sales will be reported Friday and are expected at -0.2% m/m vs. -16.6% in April. Last week, May building permits came in at -7.0% m/m and housing starts came in at -14.4% m/m. Yet that's what Fed tightening is supposed to do and should come as no surprise with mortgage rates rising sharply. Weekly mortgage applications are the only U.S. data point today.
Canada reports May CPI data. Headline is expected at 7.3% y/y vs. 6.8% in April, while common core is expected at 3.4% y/y vs. 3.2% in April. Yesterday, April retail sales data came in firm. Headline sales came in at 0.9% m/m vs. 0.8% expected and a revised 0.2% (was 0.0%) in March, while sales ex-autos came in at 1.3% m/m vs. 0.6% expected and a revised 2.6% (was 2.4%) in March. Jobs growth remained strong in May and should continue to support consumption. With the economy running hot and inflation still rising, the Bank of Canada will continue tightening aggressively. A 50 bp hike at the next meeting July 13 is fully priced in, with 75% odds of a 75 bp move. Looking ahead, the swaps market is pricing in 225-250 bp of tightening over the next 12 months that would see the policy rate peak between 3.75-4.0%, down from 4.0% last week but up from 3.0% at the start of this month.
EUROPE/MIDDLE EAST/AFRICA
The ECB seems to be following a policy of strategic ambiguity regarding its planned crisis tool. While the bank has said that it aims to wrap up preparations by the next decision on July 21, we do not get the sense that the bank is going to have its bazooka moment yet. That only comes when market dislocations become too great to ignore and we are certainly not there yet as peripheral spreads have come in. Of note, WIRP suggests a 25 bp hike July 21 is fully priced in. Then, 50 bp hikes are now priced in for the subsequent three meetings on September 8, October 27, and December 15 that would take the deposit rate to near 1.25% by year-end. Looking ahead, the swaps market is now pricing in 275 bp of tightening over the next 24 months that would see the deposit rate peak near 2.25% vs. 2.0% at the start of last week and 1.75% before the ECB meeting.
Italy is back in the headlines due to rising political risks. Foreign Minister Di Maio quit his Five Star Movement over its refusal to back military support for Ukraine. Di Maio used to lead the Five Star Movement but said he would start a new parliamentary group and follows days of sniping with former Prime Minister Conte and the current Five Star leader. Di Maio and Prime Minister Draghi are in favor of great military support for Ukraine, while Conte is opposed to sending weapons to Ukraine. Di Maio will remain Foreign Minister but said that Five Star “had the duty to support the government without ambiguity. At this historical juncture, supporting European and Atlanticist values cannot be considered a fault.” Draghi’s ruling coalition should remain intact but Five Star is the largest party in parliament and so the intra-party fighting must be watched closely. Italian spreads to Germany have come down on optimism regarding the ECB’s planned crisis tool, but rising Italian political risk is likely to limit further tightening of this key differential.
U.K. reported May CPI data. Headline came in as expected at 9.1% y/y vs. 9.0% in April, core came in a tick lower than expected at 5.9% y/y vs. 6.2% in April, and CPIH came in a tick higher than expected at 7.9% y/y vs. 7.8% in April. Headline was the highest since March 1982 and it’s likely to get worse, as the Bank of England raised its forecast for peak inflation this year to “slightly above” 11% to reflect the planned increase in the household energy price cap in October. After the Bank of England promised more “forceful” action to combat inflation, this latest round of data should cement larger 50 bp increases ahead. WIRP suggests a 50 bp hike move at the August 4 meeting is fully priced in with some small odds of a 75 bp move. 50 bp hikes are pretty much priced in for the subsequent meetings September 15 and November 3. Looking ahead, the swaps market is now pricing in 225 bp of tightening over the next 12 months that would see the policy rate peak near 3.5%, steady from the start of last week but up from 2.5% in late May. Cunliffe speaks today.
South Africa reported May CPI. Headline came in at 6.5% y/y vs. 6.1% expected and 5.9% in April, while core came in as expected at 4.1% y/y vs. 3.9% in April. Headline was the highest since January 2017 and well above the 3-6% target range. At the last meeting May 19, SARB hiked rates 50 bp to 4.75% by a 4-1 vote, with the dissent in favor of a smaller 25 bp move. Its models were updated to show a steeper expected rate path, with the policy rate seen at 5.3% by year-end vs. 5.06% in March and then rising to 6.74% by end-2024 vs. 6.68% in March. Compare this to the swaps market, which is pricing in a year-end rate near 6.25% and a policy rate near 7.25% by mid-2023 and 8.0% by mid-2025. Next policy meeting is July 21 and another 50 bp hike then seems likely.
Czech National Bank is expected to hike rates 100 bp to 6.75%. However, the market is split as a couple of analysts look for a 75 bp hike, nearly an equal number of analysts see either a 100 or 125 bp hike, and one sees a 150 bp hike. The swaps market is pricing in only 75 bp of tightening over the next 6 months that would see the policy rate peak near 6.5%. However, that should be more than met today and we see further upside risks as price pressures remain strong. CPI rose 16.0% y/y in May, the highest since December 1993 and well above the 1-3% target.
ASIA
The Bank of Japan minutes are worth discussing. At the April 27-28 meeting, some board members said the bank needed to clearly communicate that monetary policy was aimed at meeting its inflation target rather than influencing exchange rates. A few acknowledged that excessive FX moves would lead to increased uncertainties for businesses but one said the yen’s depreciation has had a positive impact. The bank reportedly discussed the relationship between monetary policy and exchange rates. One board member noted that overseas investors had increased speculation over 10-year JGB yields. Right before the April 27-28 meeting began, USD/JPY was trading around 127 and has since risen 7% to trade above 136. The market has also tested YCC several times recently and so the June 16-17 meeting likely continued to focus on the same broad themes as the April meeting did.
Prime Minister Kishida is coming under fire for high inflation as campaigning for Upper House elections begins. Kenta Izumi, head of the opposition Constitutional Democratic Party, used the term “Kishida inflation” in an effort to tie him directly to the financial hardships brought by high inflation. Kishida defended his government’s economic policies during a televised debate yesterday. He noted that “Monetary policy has a powerful effect on foreign exchange rates. But it also affects small, medium and micro-enterprises and mortgage interest rates. In other words, it has a powerful effect on the whole economy.” Campaigning for the July 10 election is likely to intensify in the coming weeks and recent polls suggest support for Kishida has fallen as a result of high inflation. The latest Nikkei poll showed his support falling six percentage points to 60% this month, the lowest since February. Nearly 70% said they didn’t approve of Kishida’s handling of inflation.
