• Markets are still digesting yesterday’s CPI data; July PPI will be reported today; Fed tightening expectations continue to adjust; Fed speakers continue spreading a very hawkish message; the heavy slate of Treasury issuance this week concludes; Mexico is expected to hike rates 75 bp to 8.50%; Peru is expected to hike rates 50 bp to 6.50%
• German Chancellor Scholz promised more relief for its citizens; ECB tightening expectations have stabilized
  
• The PBOC has pivoted; further easing now seems unlikely
  

The dollar is softer in the wake of the CPI data. DXY is down for the fourth straight day and is trading just below 105 currently. The June 27 low near 103.673 is coming into view. The euro rally yesterday ran out of steam near $1.0360, which is the 62% retracement objective of the June-July drop. It is testing that level again today and a clean break above would set up a test of the June 27 high near $1.0615. Sterling is taking advantage of broad dollar weakness and is on track to test its June 27 high near $1.2330. USD/JPY traded as low as 132 yesterday before seeing a slight bounce but appear on track to test the August 2 low near 130.40. We maintain our strong dollar call but acknowledge that a period of weakness is likely to be seen until markets readjust Fed tightening expectations. Hawkish Fed officials are doing their part (see below) but we need to continue seeing strong U.S. data.

AMERICAS

Markets are still digesting yesterday’s CPI data. Headline came in at 8.5% y/y vs. 8.7% expected and the 9.1% peak in June, while core came in at 5.9% y/y vs. 6.1% expected and 5.9% in June. In m/m terms, headline came in flat vs. 1.3% in June while core came in at 0.3% vs. 0.7% in June. The data led to a rally in equities and bonds, while the dollar came under pressure as market reassessed Fed tightening expectations. We stress that there is a lot of noise right now even as markets remain thin during the summer months. We are likely to continue seeing violent moves in the markets in the coming weeks as markets continue to struggle finding a stable and sustainable macro outlook to trade on. Recession? Soft landing? Tightening? Easing? All of these questions remain unanswered right now and we will not know the truth for months, if not quarters.

July PPI will be reported today. Headline is expected at 10.4% y/y vs. 11.3% in June, while core is expected at 7.7% y/y vs. 8.2% in June. Of note, headline peaked at 11.6% in March while core peaked at 9.6% in March. While some inflation measures are showing signs of turning lower, it is way too early for the Fed to declare victory. Weekly jobless claims will also be reported.

Fed tightening expectations continue to adjust. WIRP now showing only 45% odds of a 75 bp hike at the September 20-21 FOMC meeting vs. 80% before the CPI data. Looking ahead, the swaps market is now pricing in a 3.5% terminal rate vs. 3.75% at the start of this week. We think the markets are once again overreacting to one data point. The battle to lower inflation is likely to be long and protracted, with most Fed policymakers looking at an extended tightening cycle. Yes, we may have seen the worst in terms of inflation, but we are a long way from the Fed’s 2% target. Markets should also reprice the more dovish expectations in the coming days and weeks.

Fed speakers continue spreading the hawkish message. Evans said the Fed will hike rates for the rest of this year and into 2023, adding that he sees the Fed Funds range at 3.25-3.5% by year-end and 3.75-4.0% by end-2023. He acknowledged that the July inflation was better than prior months but added that inflation is “unacceptably high.” Evans noted that the employment numbers continue to be “so strong” and that he is not looking for recession. As we suspected, one good CPI report really shouldn't sway Fed thinking at all. The Fed has been pretty clear that it will continue hiking and keep rates higher for longer.

Kashkari unleashed his inner hawk. He noted that the July CPI data did not change his expected rate path, though he was happy to see inflation surprise to the downside. Kashkari said he wants the Fed Funds rate at 3.9% by year-end and 4.4% by end-2023. He stressed that the Fed is far from declaring victory over inflation and stressed that recession “will not deter me” from getting to the 2% target. It's amazing how far Kashkari has swung from uber-dove to uber-hawk. The Fed's communication strategy remains intact. The only question to me is when will the markets start listening? Daly speaks today and should maintain the same message.

The heavy slate of Treasury issuance this week concludes. Treasury will sell $21 bln of 30-year bonds today. At the previous 30-year auction, indirect bidders took 73.2% and the bid/cover ratio was 2.44. Demand should be strong. Yesterday’s $35 bln of 10-year notes saw very strong demand, as indirect bidders took 74.5% vs. 61.3% previously and the bid/cover ratio was 2.53 vs. 2.34 previously. This followed a strong $42 bln sale of 3-year notes Tuesday, with indirect bidders taking 63.1% vs. 60.4% previously and the bid/cover ratio at 2.50 vs. 2.43 previously.

Banco de Mexico is expected to hike rates 75 bp to 8.50%. At the last policy meeting June 23, the bank hiked rates 75 bp to 7.75%. The vote was unanimous and the bank said “For the next policy decisions, the Board intends to continue raising the reference rate and will evaluate taking the same forceful measures if conditions so require.” Earlier this week, July CPI was reported. Headline came in at 8.15% y/y vs. 7.99% in June, while core came in at 7.65% y/y vs. 7.49% in June. of note, headline was the highest since December 2000 and further above the 2-4% target range. The swaps market is pricing in 175 bp of further tightening over the next 6 months that would see the policy rate peak near 9.50% but we see some upside risks.

Peru central bank is expected to hike rates 50 bp to 6.50%. The bank has been hiking rates all year in 50 bp clips and we see no reason why it would change now. CPI rose 8.74% y/y in July, just below the cycle high of 8.81% in June and well above the 1-3% target range. Bloomberg consensus sees the policy rate peaking at 6.5% but given high inflation, we believe that it’s too soon to be thinking about the end of the tightening cycle. Forward guidance today will be key.

EUROPE/MIDDLE EAST/AFRICA

German Chancellor Scholz promised more relief for its citizens. In his first summer press conference, Scholz stressed that “We are facing serious times, I think everyone in this country knows that. We will do everything we can to ensure that citizens get safely through this period.” He promised another relief package and also backed a plan earlier this week from Finance Minister Lindner that would adjust income tax brackets to account for higher inflation, which would address so-called “bracket creep.” With Germany slipping into recession even as inflation hits record highs, polls suggest support for Scholz’s SPD has slipped to third in the polls behind the Greens and the CDU/CSU bloc. The good news is that its relatively strong budgetary position gives Germany the wherewithal to implement some fiscal stimulus.

ECB tightening expectations have stabilized. WIRP suggests a 50 bp hike is nearly 90% priced in for September 8. The swaps market is pricing in 125-150 bp of tightening over the next 12 months that would see the deposit rate peak between 1.25-1.5%, steady from the start of this week but up from 125 bp at the start of last week.

ASIA

The People’s Bank of China has pivoted. The bank said it will safeguard the economy against high inflation and pledged not to rely on excessive monetary stimulus to boost growth. In its quarterly monetary policy report, the PBOC said it will act to both support economic growth and maintain stable prices by providing stronger and higher-quality support to the economy. It noted that “Structural inflation pressure may increase in the short term, and the pressure of imported inflation remains. We can’t lower our guards easily.” The bank added that inflation will likely exceed the 3% target in some months in H2 but said it will likely achieve the target for the full year due to measures taken to ensure grain and energy supplies as well as its prudent monetary policy. The pivot comes a day after China reported lower than expected July CPI and PPI readings, making the pivot all the more surprising to us.

Further PBOC easing now seems unlikely. With the economy growing only 0.4% y/y in Q2 and the full year growth target of “around 5.5%” clearly in danger, we expected further stimulus in H2. However, it seems that policymakers are getting more concerned about inflation risks, at least enough to take their foot of the accelerator. That said, we see very little risk of tightening anytime soon. That means that monetary policy divergence with the Fed will still continue, albeit all from the U.S. side.