• Sentiment turned south yesterday after the weak 10-year UST auction; financial conditions tightened last week by the most since last October; weekly jobless claims will be closely watched; BOC released the summary of its deliberations; the market is split on Banxico decision; Peru central bank is expected to keep rates steady at 5.75%
  
• ECB Governing Council member Rehn downplayed the latest market turmoil; Turkey central bank released its quarterly inflation report
  The summary of opinions for the July BOJ meeting show discussions for a very gradual tightening cycle; Japan reported June current account data; 
• RBA Governor Bullock doubled down on the hawkish rhetoric; RBNZ released its survey of inflation expectations for Q3; India kept rates steady at 6.5%, as expected

The dollar is modestly softer on fragile market sentiment. DXY is trading lower near 103.129. The yen and Swiss franc are outperforming, with USD/JPY back near 146 after trading above 147 yesterday. Sterling is trading flat near $1.2295, while the euro is trading flat near $1.0930. While the Fed is widely 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

Sentiment turned south yesterday after the weak 10-year UST auction. U.S. equities reversed course and ended the day down, and this has carried over into global equity markets today. Even a moderately dovish BOJ summary of opinions from last week’s meeting (see below) has done little to boost appetite. The uneasy calm may extend into next week, when some top tier U.S. data should give the markets a better handle on the U.S. economic outlook. Until then, the only thing we are confident about is that volatility will remain heightened across all markets.

The market is still mispricing the Fed. The market is still fully pricing in 100 bp of easing by year-end, while the odds of another 25 bp on top of that have risen to around 40%. 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 back to pricing in 200 of total easing over the next 12 months. 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. Barkin speaks today.

According to the Chicago Fed, financial conditions tightened last week by the most since last October. If markets remain calm, we expect this tightening to reverse this week and conditions should continue to loosen in the runup to the September 17/18 FOMC meeting. We think it's clear from recent Fed comments that there is little appetite for an intra-meeting cut, and rightfully so. Given the Fed’s concerns about the labor market, we think it will be happy to see the market do some of the easing for them.

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

Weekly jobless claims will be closely watched. Initial claims are expected at 240k vs. 249k last week, while continuing claims are expected at 1.871 mln vs. 1.877 mln last week. Markets will be on guard for further signs of softness in the labor market.

Bank of Canada releases the summary of its deliberations Wednesday. At the July meeting, the bank delivered its second straight 25 bp cut and signaled more to come. The summary showed that governing council members were particularly concerned with emerging slack in the labor market. The implication is that tomorrow’s July jobs data will be a key driver of interest rate expectations. The swaps market is pricing a total of 150 bp of easing over the next 12 months, which limits CAD upside momentum.

Banco de Mexico meets, and the market is split. Nearly half the 28 analysts polled by Bloomberg see no change, while the rest look for a 25 bp cut to 10.75%. At the last meeting June 27, the bank kept rates steady at 11.00% by a 4-1 vote, with the dissent in favor of a 25bps cut. Governor Rodriguez later said rates cuts will be “on the table” in the next meetings. Ahead of the decision, Mexico reports July CPI. Headline is expected at 5.53% y/y vs. 4.98% in June, while core is expected at 4.02% y/y vs. 4.13% in June. If so, headline would accelerate for the fifth straight month to the highest since May 2023 and move further above the 2-4% target range. The bank could cut rates due to falling core inflation, but we see risks of a hawkish surprise if headline picks up as much as expected. The swaps market is pricing in 50 bp of easing over the next three months and 175 bp of total easing over next 12 months. n

Peru central bank is expected to keep rates steady at 5.75%. However, nearly a third of the analysts polled by Bloomberg see a 25 bp cut to 5.5%. The central bank has kept rates steady at 5.75% for two straight meetings due to persistent core inflation. Last week, July headline inflation came in at 2.13% y/y vs. 2.29% in June and core inflation came in at 3.02% y/y vs. 3.12% in June. As such, we see risks of a dovish surprise today.

EUROPE/MIDDLE EAST/AFRICA

ECB Governing Council member Rehn downplayed the latest market turmoil. Rehn pointed out “it was an overreaction of market forces in the conditions of uncertainty and thin market liquidity during the holiday season, not so much due to issues arising from the fundamentals of the economy.” We agree. Rehn also acknowledged the ECB can continue easing and noted that "Inflation continues to slow down but the path to the two percent target remains bumpy this year.” Rehn added that rate cuts would help the eurozone economy recover, particularly what he called "fragile" industrial growth and subdued investment. Next meeting is September 12 and a 25 bp cut is fully priced in, with follow-up cuts in October and December also priced in. Looking ahead, the swaps market is pricing in 150 bp of total easing over the next 12 months.

Turkey central bank released its quarterly inflation report. The bank kept its end-2024 and end-2025 inflation forecasts unchanged at 38% and 14%, respectively. Governor Karahan said “We see a balancing on the demand side. Therefore, we didn’t see a reason to change our predictions taking into account data that’s been in line with our forecasts.” However, he maintained hawkish stance, noting “We need to see a marked and lasting deceleration in main inflation dynamics. It’s clear that there is a drop in inflation rates recently. But we aren’t sufficiently sure that it’s here to stay.” The swaps market is still pricing in nearly 500 bp of easing over the next three months, which we believe is very unlikely.

ASIA

The summary of opinions for the July 30-31 BOJ meeting was released. At that meeting the BOJ decided by a 7-2 majority vote to raise the policy rate 15 bp “to remain at around 0.25%” from a target range of 0-0.10% previously. One board member said, “As the level of the neutral rate seems to be at least around 1%, in order to avoid rapid hikes in the policy interest rate, the bank needs to raise the policy interest rate in a timely and gradual manner.” Another said, “It should be noted that raising the rate at a moderate pace means an adjustment in the degree of monetary accommodation in accordance with underlying inflation, which will not have monetary tightening effects.” One dissent said “There is little data confirming sustainable growth in Japan’s economy at this point. I am therefore dissent on raising the policy interest rate.”

Overall, the BOJ seemed to be discussing a very gradual tightening cycle. As such, we suspect officials were taken aback by the outsized market reaction that followed. However, Deputy Governor Uchida’s dovish pivot yesterday has reset BOJ policy so that future decisions will depend in large part on stable market conditions. The BOJ is now only expected to hike 15-20 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.

Japan reported June current account data. The adjusted surplus came in at JPY1.776 trln vs. JPY2.276 trln expected and JPY2.406 trln in May. However, the investment flows will be of more interest. The June data showed that Japan investors were net sellers of U.S. bonds (-JPY2.099 trln), the most time since September 2022. Japan investors turned net buyers (JPY40.0 bln) of Australian bonds after five straight months of net selling and turned net buyers of Canadian bonds (JPY42.8 mln) again. Investors turned sellers of Italian bonds (-JPY12.8 bln) after two straight months of net buying. Overall, Japan investors turned total net sellers of foreign bonds (-JPY3.774 trln), the most since June 2022. With Japan yields likely to move even higher in H2, it’s possible that Japan investors will stop chasing higher yields abroad, but we think it’s still too early to say.

RBA Governor Bullock doubled down on the hawkish rhetoric. Yesterday, the RBA delivered a hawkish hold. Today, Bullock cautioned the board “will not hesitate to raise rates if it needs to” and added that “we don’t see interest rates coming down quickly.” The market is still pricing in a 25 bp rate cut by year-end. That’s about right in our view.

RBNZ released its survey of inflation expectations for Q3. 2-year inflation expectations fell to 2.03% in Q3 vs. 2.33% in Q2, while 1-year expectations fell to 2.3% vs. 2.5% in Q2. Both were the lowest in three years. The sharp decline in inflation expectations towards the 2% target raises the likelihood of a 25 bp rate cut next week and is weighing on NZD, with odds rising 75% from 50% yesterday. That said, we still think the RBNZ can afford to wait for October before slashing rates.

Reserve Bank of India kept rates steady at 6.5%, as expected. The vote was 4-2 to keep rates on hold, with the dissents in favor of a 25 bp cut. This was the same as the June 7 decision to hold. It was a hawkish hold, as the bank also voted to keep its stance at “withdrawal of accommodation.” Governor Das warned that the bank “has to remain vigilant to prevent spillovers or second round effects from persistent food inflation and preserve the gains made so far in monetary policy credibility.” Despite the hawkish stance, the swaps market is pricing in 25 bp of easing over the next three months followed by another 25 bp over the subsequent three months.