- Fed officials remain hawkish; August Chicago Fed NAI came in weaker than expected; the U.S. yield curve warrants further discussion; we get some minor U.S. data today; Brazil COPOM minutes and mid-September IPCA inflation will be reported
- U.K. markets have stabilized, at least for now; the Bank of England delivered nothing of substance to support U.K. assets; FX intervention to support the pound is highly unlikely; Nord Stream officials are reporting damage to its pipeline system; ECB President Lagarde is sounding less hawkish; Italian yields are rising; Hungary is expected to hike the base rate 100 bp to 12.75%
- Japan yields continue to rise; markets will continue testing the BOJ
The dollar is modestly lower as market sentiment stabilizes. DXY is down for the first time after five straight up days and is trading below114 currently. We believe it will eventually test yesterday’s cycle high near 114.527. Sterling is the best performer today as markets calm down a bit but we see weakness resuming (see below). Cable is trading just above $1.08 but we look for an eventual test of yesterday’s new all-time low near $1.0350. USD/JPY is creeping higher to trade near 145 as markets test the BOJ’s resolve (see below). The euro is underperforming on reports of damage to the Nord Stream pipeline as well as rising concerns about Italy (see below). It is currently trading near $0.9630 after making a new cycle low yesterday near $0.9555. It should test that low soon and move on to the target at the psychological $0.90 level. The combination of ongoing risk off impulses and repricing of Fed tightening risks is likely to keep the dollar bid across the board near-term. With the outlook for the rest of the world still worsening, the global backdrop continues to favor the dollar and U.S. assets in general.
Fed officials remain hawkish. Evans, Powell, Bullard, Kashkari, and Daly speak today. Evans said he is line with the Fed’s median projections and that “By spring of next year we are going to get to a funds rate that we can sort of sit and watch how things are behaving.” He added that “The exact timing of that path to me is less important than the fact that we continue to get to the point where we think we ought to be. Whether or not it’s a larger increase at the next meeting or continued increases to get there, before very long if you just look everybody’s projections we’ve pretty much got the same spot by March.” Collins, Bostic, Logan, and Mester spoke yesterday. In her first appearance as Boston Fed President, Collins toed the line and noted that further tightening is needed as the Fed seeks “clear and compelling” signs that inflation is falling. She added that lowering inflation requires somewhat higher unemployment. Bostic said "We still have a ways to go" to get inflation lower. Mester acknowledged that “While this has been a relatively fast pace of tightening, given the current level of inflation and the outlook, I believe that further increases in our policy rate will be needed.” She stressed that policy “will need to be in a restrictive stance, with real interest rates moving into positive territory and remaining there for some time.”
Fed tightening expectations remain elevated. WIRP suggests another 75 bp hike is almost fully priced in for November 2, as is a follow-up 50 bp hike December 14. Elsewhere, the swaps market is pricing in a terminal rate of 4.75%. As a result, U.S. rates continue to rise. The 2-year yield traded near 4.35% yesterday, the highest since August 2007, while the 10-year yield traded near 3.93% yesterday, the highest since April 2010. The real 10-year yield traded near 1.62% yesterday, the highest since 2010. All have come down slightly today but this generalized increase in U.S. yields is likely to continue and will ultimately support the dollar.
August Chicago Fed National Activity Index came in weaker than expected. It came in at 0.00 vs. 0.23 expected and a revised 0.29 (was 0.27) in July. As a result, the 3-month moving average rose to 0.01 vs. a revised -0.08 (was -0.09) in July. The zero reading means the economy is growing at around trend. The resilience in the economy is noteworthy and suggests the Fed has more work to do in getting the desired sub-trend growth. Recall that when that 3-month average moves below -0.7, that signals imminent recession and we are still well above that threshold. Taken along with the steeper 3-month to 10-year curve, we don’t expect a recession over the next 12 months. Further out than that is to be determined. The Atlanta Fed’s GDPNow model is currently tracking Q3 growth at 0.3% SAAR, down from 0.5% previously. The next model update will be today. We get another look at Q2 GDP Thursday and consensus sees no change at -0.6% SAAR. Of course, this is old news and markets are already looking beyond. Of note, Bloomberg consensus sees Q3 at 1.4% SAAR and Q4 at 1.0% SAAR.
The U.S. yield curve warrants further discussion. The 3-month to 10-year curve traded at 70 bp yesterday, the steepest in July before falling to 54 bp currently. It seems its divergence with the 2- to 10-year curve has been reinstated. We saw divergence widen from late 2021 to mid-2022 as the 3-month to 10-year curve steepened even as the 2- to 10-year curve inverted. The former finally played some catch up with the latter over the summer but now divergence has resumed in September. Bottom line: we do not think the yield curve is signaling imminent recession yet.
We get some minor U.S. data today. Regional Fed manufacturing survey for September will wrap up with the Richmond Fed. It is expected at -10 vs. -8 in August. Yesterday, the Dallas Fed came in at -17.2 vs. -9.0 expected and -12.9 in August. July FHFA and S&P CoreLogic house price indices and August new home sales (-2.2% m/m expected) will also be reported today, along with August durable goods orders (-0.3% m/m expected) and September Conference Board consumer confidence (104.5 expected).
Brazil COPOM minutes and mid-September IPCA inflation will be reported. At last week’s meeting, rates were left unchanged at 13.75%, as expected. This was the first hold after 12 straight hikes but the vote was split 7-2 with the dissents in favor of a 25 bp hike. Minutes may offer some clues to future policy, though most expect the tightening cycle has ended. Inflation is expected at 8.14% y/y vs. 9.60% in mid-August. If so, it would be the lowest since mid-June 2021 but still above the 2-5% target range. Next policy meeting is October 26 and no change is expected then. However, markets are pricing in the start of an easing cycle at the March COPOM meeting.
U.K. markets have stabilized, at least for now. Gilt yields have edged lower while sterling has edged higher, but the bulk of the moves remain intact. Some analysts believe the market overreacted to what was a widely telegraphed move, while most others say the moves were warranted in light of an historic policy misstep. Perhaps the truth is somewhere in between but we believe that the direction for U.K. remains unchanged. That is, the proposed tax cut experiment will do nothing to reverse what we see as totally warranted negative sentiment on the U.K. To us, this negative shift in sentiment began with Brexit and has intensified as U.K. politicians and policymakers have made countless missteps and mistakes that have compounded the deteriorating situation. Until the Truss government reverses its fiscal stance, we cannot see how sentiment turns around. We must also stress that such a reversal is a necessary but not sufficient condition to stabilizing market sentiment as the government risks further erosion of credibility.
The Bank of England delivered nothing to support U.K. assets. In its emergency statement delivered yesterday, Governor Bailey said the bank is monitoring developments in the financial markets closely and won’t hesitate to change rates by as much as needed. However, he said the MPC will make a full assessment of the situation at its next scheduled meeting in November. As one might expect, the lack of any concrete measures beyond these vague statements of concern led to another round of selling U.K. assets. Next BOE meeting is November 3, an eternity by market standards. If sterling weakness resumes in force, this may force either the BOE or the Truss government to act much sooner than that. BOE rate hikes probably won't do much until the fiscal stance is reversed. Let's see how stubborn Truss and Kwarteng can be. And Bailey too for that matter.
FX intervention to support the pound is highly unlikely. The BOE has foreign reserve holdings of around $108 bln. Compare this to the BOJ with $1.18 trln. Press reports suggest the BOJ spent around $25 bln last week defending the yen, which accounts for around 2% of its total holdings. If the BOE were to do a similar operation, it would account for nearly 25% of its total holdings and so this is option is a non-starter. We don't want to make too much of this EM/DM question for the UK that’s been making the rounds but we do want to emphasize that this sort of "do they have enough reserves?" exercise is typically one we do for EM countries coming under pressure.
Bank of England tightening expectations have picked up as a result of the fiscal stimulus. Is there anything the BOE can do to support the pound? They just met last week and hiked a lackluster 50 bp but would 75 or 100 bp really have made much difference? Sentiment was already poor but the tax package simply poured gasoline on the fire. We don't think any sort of emergency BOE rate hike would do much to support the currency beyond a brief knee-jerk reaction. As it is, WIRP suggests a 150 bp hike is almost fully priced in for November 3 while the swaps market is pricing in a peak policy rate near 5.75% over the next 12 months, up from 4.5-4.75% at the start of last week. Yet this has done nothing for sterling. Market confidence, once lost, is always difficult to regain.
Nord Stream officials are reporting damage to its pipeline system. The company said “The destruction that happened within one day at three lines of the Nord Stream pipeline system is unprecedented. It’s impossible now to estimate the timeframe for restoring operations of the gas shipment infrastructure.” Germany said it is investigating three leaks in the Baltic Sea from damaged pipelines. According to the Swedish Coast Guard, the leaks were so large that they showed up on the radars of vessels in the vicinity. The actual impact may be limited as the pipelines were already running at very low levels but it’s clear that a return to a more “normal” flow of Russian natural gas to Europe remains far away.
ECB President Lagarde is sounding less hawkish. She said yesterday that the bank will consider Quantitative Tightening (QT) once interest rate normalization is completed. This is quite different from the Fed playbook, which has seen QT start once rate normalization has gotten under way but still ongoing. We think the ECB is being more cautious because it has to worry about fragmentation risks. Bottom line: a bit more dovish than anticipated. Lastly, Lagarde pledged the Outright Monetary Transactions (OMT or QE) is available if its Transmission Protection Instrument (TPI) fails. This is not exactly a strong vote of confidence in its newly created TPI. Of note, WIRP suggests another 75 bp is almost fully priced in for the next meeting October 27, while the swaps market is pricing in 225-250 bp of tightening over the next 12 months that would see the deposit rate peak between 3.25-3.50%, up from 2.75% at the start of last week.
Italian yields are rising as markets focus on the hurdles seen in the coming weeks for the incoming government. After the election results were announced, the 10-yaer spread to Germany has risen to 249 bp currently, the highest since June 2019. The May 2019 high comes in near 287 bp followed by the November 2018 high near 312 bp. Italy is clearly underperforming as other peripheral spreads are still lower than their mid-2022 peaks. While the right-wing alliance remains intact and Brothers of Italy head Meloni tipped to become Prime Minister, it will still take weeks to form a government and dole out the top cabinet positions amongst the main parties. Of course, the choice of Finance Minister is key and markets will be closely watching their work on the 2023 budget, which must be approved by both parliament and the EU.
National Bank of Hungary is expected to hike the base rate 100 bp to 12.75%. However, a third of the analysts polled by Bloomberg see a smaller 75 bp move. At the last policy meeting August 30, the bank hiked rates 100 bp to 11.75% and said it needs to continue hiking due to inflation risks. It also raised required reserves ratios for commercial banks at that meeting. CPI rose 15.6% y/y in August, the highest since May 1998 and further above the 2-4% target range. Of note, the bank should also raise its 1-week deposit rate at its weekly tender Thursday to match today’s hike in the base rate.
Japan yields continue to rise. The 10-year yield rose to the 0.25% upper limit under Yield Curve Control, while the 20-year yield rose above 1.0% for the first time since 2015. This lead the Bank of Japan to call an unscheduled round of bond purchases and bank ended up buying JPY150 bln of 5- to 10-year notes and JPY100 bln of 10- to 25-year bonds. It also conducted an unlimited bond purchase operation for 10-year notes in order to maintain YCC.
The markets will continue testing the Bank of Japan. In the FX space, USD/JPY continues to creep higher to trade just below 145 and is likely to test the 145.90nhgh from last week. Markets recognize that BOJ cannot have its cake and eat it too. By maintaining ultra-loose policy and YCC, the bank will only encourage further yen weakness. BOJ intervention may have introduced more two-way risk in the FX market but it has not reversed the weak yen trend. Only a pivot to a less dovish stance can do that and it’s clear the BOJ is not ready to do that yet. Indeed, we see steady policy through at least the end of Governor Kuroda’s term in April.