• The market is still mispricing the Fed; financial conditions for last week will be reported; BOC releases the summary of its deliberations; Canada also reports July Ivey PMI
  
• Germany reported soft June IP and trade data
  
• BOJ is engaging in damage control; New Zealand reported firm Q2 employment data; China reported July trade data; recent strength in the yuan is puzzling

The dollar continues to recover as the calm extends. DXY is trading higher for the second straight day near 103.239 and has retraced over a third of its post-FOMC drop. Key retracement levels to watch are 103.480 and 103.791. The yen is the worst performing major again after dovish damage control from the BOJ (see below) and is trading back above 147 after trading as low as 141.70 Monday. Sterling is trading higher near $1.2715, while the euro is trading lower near $1.0920 after trading above $1.10 Monday. NZD is outperforming on firm Q2 employment data. While the Fed is expected to cut rates in September, we continue to believe that markets are overreacting to the recent softness in the U.S. data. Looking at the totality of the data, the economy is still growing above trend and suggests the market is once again getting carried away with its pricing for aggressive easing (see below). We continue to believe that the divergence story remains in place and should continue to support the dollar. However, it will likely take weeks for the current market narrative to run its course.

AMERICAS

The calm that began yesterday has carried over to today. Global equity markets rose for the second straight day, led by Japan after dovish BOJ comments (see below), while global bond yields are edging higher. The havens JPY and CHF are down sharply, while high yielders such as MXN and ZAR are outperforming. Of course, market sentiment remains vulnerable but for now, we are happy to move past the panic phase.

The market is still mispricing the Fed. To wit, the market is still fully pricing in 100 bp of easing by year-end, but the odds of another 25 bp on top of that have fallen to 15% vs. with 55% Monday. This still incorporates nearly 80% odds that the Fed’s first cut in September will be 50 bp vs. 90% Monday. Looking further ahead, the market is pricing in 175-200 of total easing over the next 12 months vs. over 200 bp Monday. Unless the U.S. economy falls into a deep recession, this rate path still seems unlikely. However, we cannot stand in the way of this dovish narrative until we see more data. June consumer credit today is unlikely to have any market impact.

Chicago Fed financial conditions for last week will be reported. Lower yields tend to loosen financial conditions, but this was offset by falling equity markets and widening credit spreads. We’re not sure how this will net out, but we remain confident that financial conditions are likely to continue loosening in the run-up to the first cut next month. It seems like an eternity until the September 17-18 FOMC meeting. Given the Fed’s concerns about the looser labor market, we think it will be happy to let the market do some of the easing for them after its hold last week.

The U.S. economy overall remains solid. Yes, there are pockets of weakness, but GDP still grew 2.8% SAAR in Q2. For Q3, the Atlanta Fed’s GDPNow model is tracking 2.9% SAAR and will be updated tomorrow after the data. The New York Fed’s Nowcast model is tracking Q3 growth at 2.1% SAAR and will be updated Friday. Its first estimate for Q4 will come at the end of August.

Bank of Canada releases the summary of its deliberations. At the July meeting, the bank delivered its second straight 25 bp cut and signaled more to come. The BOC scrapped previous reference that “risks to the inflation outlook remain”, pointing out instead that “with the economy in excess supply and slack in the labor market, the economy has more room to grow without creating inflationary pressures.” In fact, BOC projects both core and headline inflation reaching its 2% target in Q4 2025. The next meeting is September 4 and another 25 bp cut is fully priced in. Looking ahead, the swaps market is pricing in 150 bp of total easing over the next 12 months.

Canada also reports July Ivey PMI. We see downside risks. Yesterday, S&P Global services PMI rose two ticks from June to 47.3, but the composite PMI still fell half a point to 47.0 due to the sharp drop in its manufacturing PMI to 47.8 vs. 49.3 in June.

EUROPE/MIDDLE EAST/AFRICA

Germany reported soft June IP and trade data. Exports came in at -3.4% m/m vs. -1.5% expected and a revised -3.1% (was-3.6% in May), while imports came in at 0.3% m/m vs. 2.5% expected and a revised -5.5% (was -6.6%) % in May. In y/y terms, exports slowed to -4.4% vs. -1.1% in May, while imports picked up to -6.4% vs. -8.9% in May. IP was also reported and came in a tick higher than expected at -4.1% y/y vs. a revised -7.2% (was -6.7%) in May. The largest economy in the eurozone continues to struggle. Weak eurozone data should keep the ECB in easing mode. Next meeting is September 12 and a 25 bp cut is fully priced in, with high odds of consecutive cuts in October and December.

ASIA

Bank of Japan is engaging in damage control. As criticism of its hawkish hike mounts, Deputy Governor Uchida said, “I believe that the bank needs to maintain monetary easing with the current policy interest rate for the time being, with developments in financial and capital markets at home and abroad being extremely volatile.” Uchida added that “In contrast to the process of policy interest rate hikes in Europe and the United States, Japan’s economy is not in a situation where the bank may fall behind the curve if it does not raise the policy interest rate at a certain pace. Therefore, the bank will not raise its policy interest rate when financial and capital markets are unstable.” The BOJ is now only expected to hike 15 bp over the next 12 months, down from 50 bp expected right after its hawkish hike. Looking further out, only 35 bp of total tightening is seen over the next 3 years. That's quite the dovish pivot.

New Zealand reported firm Q2 employment data. Employment rose 0.4% q/q vs. -0.2% expected and a revised -0.3% (was -0.2%) in Q1. The unemployment rate rose to 4.6% vs. 4.7% expected and a revised 4.4% (was 4.3%) in Q1, while the participation rate came in at 71.7% vs. 71.3% expected and a revised 71.6% (was 71.5%) in Q1. Finally, private wages including overtime came in a tick higher than expected at 0.9% q/q vs. 0.8% in Q1, while the y/y rate eased two ticks to 3.6%, the lowest since Q2 2022. The market slashed the odds of a rate cut on August 14 to 50% from 90% earlier this week but still sees almost 50 bp of easing by October 9. Our base case remains for the RBNZ to start easing in October with a 25 bps cut, and we doubt the RBNZ will be as dovish as the market expects. As such, NZD has room to edge higher if global financial market risk appetite does not worsen.

China reported July trade data. Exports came in at 7.0% y/y vs. 9.5% expected and 8.6% in June, while imports came in at 7.2% y/y vs. 3.2% expected and -2.3% in June. Given the low base effects from 2023, the gains in both are rather unimpressive, making it even more important for policymakers to boost domestic activity. Indeed, the slowdown in export growth suggests global demand is weakening.

Recent strength in the yuan is puzzling. USD/CNY fell to 7.1155 during the market turmoil Monday, the lowest since January. The yuan is hardly a safe haven and so we are left believing that it was being used as a funding currency and that we saw excessive gains due to short-covering. As market turmoil eases, we expected the yuan to weaken back to levels we saw in July, as monetary policy divergences remain in favor of the dollar. To the PBOC’s credit, it kept its daily fix steady and did not try to force it higher, which makes us believe policymakers were just as surprised as we were by the yuan’s gains.