U.S. rates markets are pricing in increasing odds of a U.S. recession; April core PCE will be the U.S. data highlight; the U.S. housing sector is softening and that's what rate hikes are supposed to do; the growing imbalance means home prices need to fall and that should eventually lead to downward pressure on inflation; Banco de Mexico minutes were hawkish
Chancellor Sunak bowed to pressure and announced an aid package for U.K. households; BOE tightening expectations remain stalled
Japan reported softer May Tokyo CPI data; Australia reported firm April retail sales
The dollar is getting some limited traction ahead of the long weekend. With U.S. markets closed Monday, there may be some month-end rebalancing flows helping the dollar today. DXY is trading near 101.90 after earlier making a new low for this move near 101.433. Clean break below 101.80 would set up a test of the April 21 low near 99.818. The euro is trading back near $1.07 after trading at a new high for this move near $1.0765. Here, a clean break above $1.0710 would set up a test of the April 21 high near $1.0935. USD/JPY remains heavy near 127 as risk sentiment remains vulnerable. Sterling is trading back below $1.26 after trading at a new high for this move near $1.2665. Sterling should continue to underperform despite Sunak’s recent fiscal moves (see below). We still view this recent move lower in the dollar as a correction within the longer-term dollar rally but acknowledge that further losses are possible until the market pessimism on the U.S. economic outlook improves (see below).
U.S. rates markets are pricing in increasing odds of a U.S. recession. Of note, the swaps market is pricing in a terminal Fed Funds rate of 3.0% vs. 3.75% in early May. More importantly, it is now pricing in the start of an easing cycle sometime in the subsequent 12 months. This would only be likely if the U.S. economy were to fall into recession next year. While that is possible, it is not our base case. As a result of the shifting expectations, U.S. yields continue to fall from the early May peaks. The 10-year yield is currently trading near 2.74% vs. the May 9 peak near 3.20%,while the 2-year yield is trading near 2.47% vs. the May 4 peak near 2.85%. The 2-year differentials with Germany, Japan, and the U.K. peaked in early May and have been moving lower, which has taken the expected toll on the dollar. We continue to believe that recession fears are overblown but acknowledge that it may take some time for market sentiment to turn around. Next week brings important PMI readings and the jobs report for May. Perhaps it begins there.
April core PCE will be the U.S. data highlight. It is expected to ease to 4.9% y/y vs. 5.2% in March. if so, it would be the second straight month of deceleration but still well above the Fed’s 2% target. While this would be a welcome development, the Fed has made it clear that it will continue with its aggressive tightening over the next several meetings and so today’s data is unlikely to have much bearing on policy. Personal income and spending will also be reported at the same time and are expected to rise 0.5% m/m and 0.8% m/m, respectively. April advance goods trade (-$114.8 bln expected), wholesale and retail inventories, and final May University of Michigan consumer sentiment will also be reported.
The U.S. housing sector is softening and that's what rate hikes are supposed to do. Yesterday, April pending home sales fell -11.5% y/y vs. -7.6% expected and a revised -9.2% (was -8.9%) in March. A year ago, everyone was talking about an unsustainable housing bubble and now concerns are rising because we are finally getting a correction. This is not 2007 all over again, though. Note that existing, new, and pending home sales are all contracting y/y. On the other hand, housing starts rose 14.6% y/y, which suggests there is a growing glut of new supply just as demand is waning. As it is, the supply of new homes jumped to 9.0 months in April, the highest since May 2010 and climbing.
This imbalance means home prices need to fall and that should eventually lead to downward pressure on inflation. The CPI utilizes the Owners’ Equivalent Rent (OER) and Rent components to capture housing costs and makes up nearly a third of the CPI basket. From a recent White House study: "Despite the fact that the PCE price index (the measure most closely tracked by the Federal Reserve) incorporates the CPI: Rent and CPI: OER price indices, housing makes up a far smaller share of PCE inflation, partly because PCE is broader in scope overall and partly because PCE uses a different methodology than CPI for weighting housing. On average, housing is 16% of headline PCE and 18% of core PCE."
Banco de Mexico minutes were hawkish. At that meeting, it hiked rates 50 bp to 7.0% by a 4-1 vote, with Deputy Governor Espinosa dissenting in favor of a 75 bp hike. However, the minutes show that more policymakers were open to a larger move as another said it would reinforce the bank’s autonomy and have more impact on long-term inflation expectations. However, that official acknowledged that it would surprise markets, “making it difficult to forecast the reference rate’s trajectory.” A third policymaker said “extraordinary conditions, such as those being faced, may require extraordinary actions” and argued that “an unanchoring of expectations must be avoided by taking forceful actions.” One of these two others is likely Deputy Governor Heath, who recently noted risks of a 75 bp move next month. Next policy meeting is June 23 and the minutes suggest it will be a very close call between 50 and 75 bp. The swaps market still sees 225 of tightening over the next 12 months that would see the policy rate peak near 9.25%.
Chancellor Sunak bowed to pressure and announced an aid package for U.K. households. The package totals GBP15 bln and includes the following one-off payments: energy rebates of GBP400 to all households and GBP650 to 8 mln of the lowest income households, GBP300 to all pensioners, and GBP150 to all receiving disability benefits. It will be financed in part by a 25% windfall tax on oil and gas companies that is projected to raise about GBP5 bln. With energy prices expected to spike again in October when the household cap is adjusted, there will be pressure on Sunak to deliver even more in the months ahead but his actions come with a lot of risks attached. While the aid to households will help support consumption and perhaps help stave off recession, it may add to already high price pressures.
Bank of England tightening expectations remain stalled. WIRP suggests another 25 bp hike is priced in for the next meeting June 16. Looking ahead, the swaps market is pricing in 150 bp of total tightening over the next 12 months that would see the policy rate peak near 2.50%, steady from the start of last week. BOE Chief Economist Pill said this week that the bank knows it needs to hike rates further but is wary of acting too quickly and pushing the economy into recession. The aid package that was just announced may give the bank more confidence to hike but that has not yet been reflected in market pricing. Stay tuned.
Japan reported softer May Tokyo CPI data. Headline came in at 2.4% y/y vs. 2.5% expected and a revised 2.4% (was 2.5%) in April, while core (ex-fresh food) came in steady at 1.9% y/y vs. 2.0% expected and core ex-energy came in as expected at 0.9% y/y vs. 0.8% in April. The basically steady readings are a bit surprising as low base effects from last year and current high energy prices are still at work. If this is replicated in the national CPI data, BOJ officials will feel surely vindicated as they continue to look through this spike and maintain the current accommodative stance for the foreseeable future. Next policy meeting is June 16-17 and all policy settings are expected to remain steady.
Australia reported firm April retail sales. They came in a tick lower than expected at 0.9% m/m vs. 1.6% in March, while the y/y rate picked up to 9.6% vs. 9.4% in March. Looking ahead consumption should continue to be supported by a strong labor market that’s at full employment. The economy remains robust even as price pressures continue to rise. However, there are growing concerns that a planned July 1 price hike in electricity prices will further crimp household budgets that are already getting squeezed from inflation and rising interest rates. Stay tuned. Another 25 bp hike June 7 is fully priced in, while the swaps market sees nearly 300 bp of tightening over the next 12 months that would see the policy rate peak near 3.25%, steady from the start of last week.