U.S. yields continue to drift sideways; Fed tightening expectations have eased a bit; the slope of the U.S. yield curve is getting more concerning; Canada highlight will be June CPI data
Reports suggest the ECB may consider a 50 bp hike tomorrow; other reports suggest the ECB is struggling to reach a compromise on its new anti-crisis tool; we see four possible outcomes tomorrow; Italian politics remain in flux ahead of a planned confidence vote today; U.K. reported June CPI data; the U.K. political outlook continues to solidify; South Africa reported June CPI
The two-day BOJ meeting began today
The dollar is stabilizing ahead of the key ECB meeting tomorrow. DXY is higher today after it tested the 50% retracement objective of its June-July rally near 106.483 yesterday. Despite reports of a possible 50 bp move by the ECB tomorrow, the euro rally ran out of steam near $1.0275. We see four potential outcomes tomorrow, most of them euro-negative (see below). The weakening trend in the yen remains stalled, with USD/JPY trading near 138 after trading at a new cycle high near 139.20 last week. With BOJ dovishness likely to be maintained at this week’s meeting, we still believe the pair will eventually test the August 1998 high near 147.65. Sterling rally ran out of steam near $1.2045 and it is trading back below $1.20. 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.
U.S. yields continue to drift sideways. The 10-year yield is trading back below 3.0%, while the 2-year is trading back near 3.16%. Both remain well below their June peaks of 3.50% and 3.45%, respectively. The good news for the dollar is that yields globally are behaving similarly, and so the yield differentials remain in the dollar’s favor, at least for now.
Fed tightening expectations have eased a bit. WIRP suggests a 75 bp hike at the next meeting July 27 is now fully priced in, with nearly 25% odds of a 100 bp move. A 75 bp hike September 21 is nearly priced in, followed by 25 bp November 2. One last 25 bp hike December 14 or February 1 is priced in, which would take the Fed Funds ceiling up to 3.75%. Of note, WIRP then suggests the beginning of an easing cycle by Q1 23. Similarly, the swaps market is now pricing in 200 bp of tightening over the next 6 months that would see the policy rate peak near 3.75%, followed by the start of an easing cycle over the subsequent 6 months. This is a much earlier timeframe for easing and one that we think is very, very premature since it would imply a recession hitting the U.S. near the end of this year or early next year.
As of midnight last Friday, the Fed’s media blackout went into effect. There will be no more Fed speakers until Chair Powell’s post-decision press conference July 27. Of note, Michael Barr was sworn in yesterday as Vice Chair for supervision, which fills all seats on the Board of Governors for the first time since 2013. Barr will take part in next week’s FOMC meeting. June existing home sales will be reported. Sales are expected at -1.1% m/m vs. -3.4% in May. Yesterday, June building permits and housing starts came in at -2.0% m/m and -0.6% m/m, respectively.
The slope of the U.S. yield curve is getting more concerning. Faithful readers will know that we focus on the 3-month to 10-year curve, which until very recently was quite steep. As recently as early June, this curve was near 185 bp but has since fallen to 49 bp, the flattest since August 2020. Yes, the 2- to 10-year curve has already inverted to -0.20%, the most since September 2000, and we fully acknowledge that the 3-month to 10-year curve may follow it into inversion. However, it is not a sure thing.
Canada highlight will be June CPI data. Headline inflation is expected at 8.4% y/y vs. 7.7% in May, while common core is expected at 4.2% y/y vs. 3.9% in May. If so, headline would be the highest since December 1982. No wonder the Bank of Canada surprised markets with a 100 bp hike to 2.5% last week vs. 75 bp expected. WIRP suggests a 75 bp hike to 3.25% is almost fully priced in. Looking ahead, the swaps market is pricing in 125 bp of tightening over the next 6 months that would see the policy rate peak near 3.75%. Similar to what’s priced in for the Fed, the swaps market sees the BOC starting an easing cycle over the subsequent 6 months.
Reports suggest the ECB may consider a 50 bp hike tomorrow. However, the unnamed sources admit that there may not be sufficient support on the Governing Council for a larger move. Indeed, it would fly against the forward guidance that’s been put forth by President Lagarde and we know that the divide between the hawks and doves remains wide. While we acknowledge risks of a hawkish surprise, we believe that the bank will opt for the more cautious move. Updated macro forecasts won’t be released until the September 8 meeting, which would offer a better opportunity to accelerate its tightening path if needed. As usual, Madame Lagarde’s press conference is likely to provide the fireworks, whether good or bad. Of note, a 50 bp hike is fully priced in for September, with some odds of a 75 bp move. Looking ahead, the swaps market is now pricing in 200 bp of tightening over the next 12 months that would take the deposit rate to 1.5%, with very small odds of one last 25 bp hike over the subsequent 24 months.
Other reports suggest the ECB is struggling to reach a compromise on its new anti-crisis tool. It’s possible that the hawks are trying to leverage their support for the tool in exchange for a larger 50 bp hike. As always, we are braced for disappointment but perhaps the ECB will surprise us. As things stand, it’s very apparent that there is the usual split between the debtor and creditor nations. Bundesbank President Nagel has made it clear that the creditors remain reluctant to write a blank check to the debtors. As a result, it seems likely that the Governing Council will be unable to agree this week on the trigger and conditionality for the planned anti-crisis tool.
We see four possible outcomes tomorrow. Best case outcome for the euro would be a 50 bp hike and the announcement of an aggressive anti-crisis tool, while the worst case would be 25 bp and further delays to the tool. In between would be a 50 bp hike and no tool or a 25 bp hike and an aggressive anti-crisis tool. We think the best case outcome is highly unlikely (15%), as is a 25 bp hike and aggressive anti-crisis tool (15%). As such, we are left with the worst case outcome (35%) and 50 bp hike with no tool (35%) as the most likely outcomes. While a 50 bp hike might give the euro a knee-jerk boost, the fact that the ECB cannot come up with a credible anti-crisis tool should eventually weigh on the single currency.
Italian politics remain in flux ahead of a planned confidence vote today. Draghi told parliament that his fragile coalition could be rebuilt, noting that popular support for his government were “unprecedented and impossible to ignore.” Lawmakers will have the chance to respond to Draghi’s speech and Draghi will then get a chance to respond. If all goes smoothly, a confidence vote will be held afterwards. It’s unclear whether the Five Star Movement will ultimately support Draghi, though there have been reports of a potential breakaway faction. If the vote of confidence fails, we see no other option besides fresh elections and this would be very negative for the euro and Italian yields. Stay tuned.
U.K. reported June CPI data. Headline inflation came in at 9.4% y/y vs. 9.3% expected and 9.1% in May, core came in as expected at 5.8% y/y and 5.9% in May, and CPIH came in at 8.2% y/y vs. 8.1% expected and 7.9% in May. Headline was the highest in 40 years and further squeezes household income. The May gain in retail sales was a fluke and we expect consumption to resume weakening as a result of lower real incomes. Bank of England expectations have steadied. WIRP suggests a 50 bp hike move at the August 4 meeting is almost fully priced in. After that, 50 bp hikes are also nearly priced in for the subsequent meetings September 15 and November 3 before shifting to 25 bp December 15. Looking ahead, the swaps market is pricing in 175 bp of tightening over the next 6 months that would see the policy rate peak near 3.0%, followed by steady rate in the subsequent 6 months and then the start of an easing cycle over the following 12 months.
The U.K. political outlook continues to solidify. After the latest vote for the Tory leadership yesterday, Sunak emerged as the frontrunners with 118 votes. Mordaunt came in second with 92 votes, followed by Truss with 86. Badenoch was eliminated and her 59 votes will be key. There will be lots of horse-trading and so the situation is very fluid. The final round will be held today and will determine the final two candidates. Parliament then goes on summer recess and the final two will make their case to Tory members over the subsequent six weeks. The winner will be announced September 5.
South Africa reported June CPI. Headline came in at 7.4% y/y vs. 7.3% expected and 6.5% in May, while core came in at 4.4% y/y vs. 4.3% expected and 4.1% in May. If so, headline would be the highest since May 2009 and further above the 3-6% target range. The central bank meets tomorrow and is expected to hike rates 50 bp to 5.25%. However, over a third of the 20 analysts polled by Bloomberg look for a larger 75 bp move. At the last meeting May 19, the bank hiked rates 50 bp to 4.75%, as expected. It flagged further hikes as its models showed the policy rate at 5.30% by year-end, 6.21% by end-2023, and 6.74% by end-2024. We expect the model update to show an even steeper tightening path. The swaps market is pricing in 300 bp of tightening over the next 12 months that would see the policy rate rise to 7.75%, followed by another 75 bp of tightening over the subsequent 24 months.
The two-day Bank of Japan meeting began today. No change is expected for any of the bank’s policy settings. Updated macro forecasts will be released but are unlikely to signal any shift from its current ultra-dovish stance. Inflation forecasts may be tweaked higher but not by enough to warrant any tightening. It’s worth noting that the market has not tested the BOJ’s YCC since mid-June as the bank has underscored its commitment to maintain it for the foreseeable future. The weak yen is likely to get a mention of concern but the pace of weakening has slowed in recent weeks. USD/JPY rose nearly 6% in March, nearly 7% in April, fell 1% in May, and rose 5.5% in June. So far in July, the pair has risen about 2%. In FX, it’s typically more about the pace than any particular level and so the recent stability will be welcome. That said, if we get above the psychological 140 level, there are really no major targets until the August 1998 high near 147.65.