Euro Flat Despite Hawkish ECB Message

December 16, 2022
  • Markets are still repricing the Fed’s expected tightening path; the Fed narrative finally seems to be moving our way; yet U.S. yield have barely budged; November retail sales data came in soft; S&P Global reports preliminary December PMI readings; Colombia is expected to hike rates 100 bp to 12.0%
  • The ECB hiked rates 50 bp to 2.5%, as expected; further details about Quantitative Tightening were revealed; the fireworks came when Madame Lagarde easily out-hawked Fed Chair Powell; reports suggest more than a third of the ECB policymakers favored a 75 bp hike; eurozone preliminary December PMIs were reported; U.K. reported weak November retail sales; U.K. preliminary December PMIs were mixed; Russia is expected to keep rates steady at 7.5%
  • Japan reported mixed preliminary December PMIs; on the other hand, Australia reported soft preliminary December PMIs; China announced the creation of a new state-owned company that will buy iron ore for its domestic steel companies

The dollar is handing on to its recent gains ahead of the weekend. DXY is trading flat near 104.50 and a break above 104.915 is needed to set up a test of the December 7 high near 105.822. The euro is trading lower near $1.0630 despite the very hawkish message from the ECB yesterday (see below), while sterling is trading lower below $1.22 in the aftermath of the BOE’s rather underwhelming 50 bp hike. USD/JPY is trading lower near 137 after this latest bounce ran out of steam just above 138. We continue to believe that the fundamental outlook still favors the dollar and the Fed narrative finally seems to be shifting our way after the FOMC decision (see below).

AMERICAS

Markets are still repricing the Fed’s expected tightening path. WIRP suggests that a 25 bp hike February 1 is fully priced in, with 30% odds of a larger 50 bp move. Looking ahead, WIRP suggests a 25 bp hike March 22 is fully priced in, with around 25% odds of a final 25 bp hike May 3 or June 14 that would take the Fed Funds rate up to 5.25%. This is slightly less hawkish than the swaps market, which is pricing in a peak policy rate near 5.5%.

The Fed narrative finally seems to be moving our way. With both AHE and core PCE flat-lining near 5% for most of this year, we have long felt that a 5% Fed Funds rate would not get inflation back to target, not when the labor market remains so firm and consumption is holding up relatively well. Strangely enough, the swaps market continues to price in an easing cycle in H2 2023. This seems highly unlikely and so the mispricing continues despite the strong message from the Fed this week.

Yet U.S. yield have barely budged. The 2-year yield is trading near 4.25%, around the bottom of its recent ranges. Similarly, the 10-year yield is trading near 3.50% and is also around the bottom of its recent trading ranges. If the more hawkish Fed narrative continues to hold, we would expect U.S. yields to rise further, especially at the short end. Curve inversion remains deep and is likely to persist, raising the odds that the economy goes into recession next year. Global equity markets remain under pressures under the weight of ongoing global monetary tightening that is set to continue well into 2023.

November retail sales data came in soft. Headline came in at -0.6% m/m vs. -0.2% expected and 1.3% in October, while sales ex-autos came in at -0.2% m/m vs. 0.2% expected and a revised 1.2% (was 1.3%) in October. The so-called control group used for GDP calculations came in at -0.2% m/m vs. 0.1% expected and a revised 0.5% (was 0.7%) in October. In y/y terms, all three measures slowed modestly. That said, consumption has been running stronger than expected in recent months and so we view the November reading as some payback. Of note, the Atlanta Fed’s GDPNow model is currently tracking 2.8% SAAR growth in Q4, down from the previous estimate of 3.2% SAAR. The next model update will be Tuesday.

S&P Global reports preliminary December PMI readings. Manufacturing is expected at 47.9 vs. 47.7 in November, services is expected at 46.5 vs. 46.2 in November, and the composite is expected at 46.8 vs. 46.4 in November. Of note, the S&P Global readings have been weaker than ISM readings in recent months. Yesterday, the regional Fed manufacturing surveys kicked off with weak Empire and Philly Fed surveys. Empire came in at -11.2 vs. -1.0 expected and 4.5 in November, while Philly Fed came in at -13.8 vs. -10.0 expected and -19.4 in November. November IP also came in weak yesterday at -0.2% m/m vs. flat expected and -0.1% in October.

Colombia central bank is expected to hike rates 100 bp to 12.0%. At the last policy meeting October 28, the bank hiked rates 100 bp to 11.0%. Since then, headline inflation has continue to accelerate to 12.53% y/y in November, the highest since March 1999 and further above the 2-4% target range. The swaps market is pricing in a peak policy rate near 12.25% but we see upside risks if inflation continues to rise.

EUROPE/MIDDLE EAST/AFRICA

The European Central Bank hiked rates 50 bp to 2.5%. It said that it expected to hike rates further but will decide meeting by meeting. The bank noted that rates still need to rise significantly as inflation remain far too high and above target for far too long. Updated forecasts were released with higher inflation and lower growth projections compared to the September forecasts. The bank noted that the eurozone economy may contract in this quarter and next but added that the recession would be relatively short-lived and shallow.

Further details about Quantitative Tightening were revealed. Proceeds from the ECB’s APP holdings will be allowed to run off at an average pace of EUR15 bln per month starting in March and running through the end of Q2. The pace of run off in Q3 and beyond will be decided later but we suspect it will follow the Fed in gradually increasing the average monthly runoff in H2. Greater detail on the parameters of the runoff will be given at the February meeting. It appears that balance sheet runoff will start only on its APP holdings, as the ECB said its PEPP proceeds will be reinvested until at least end-2024. To us, starting QT at the March 16 meeting makes sense as updated macro forecasts will be released then. The bank will also have a better idea of how the eurozone economy fared during the risky winter months, when energy prices could again prove disruptive. Ahead of that, the February 2 meeting will provide the ECB with an opportunity to fine tune its policy plans, as we expected.

The fireworks came when Madame Lagarde easily out-hawked Fed Chair Powell. In her opening statement, she warned that eurozone inflation risks are primarily to the upside, with growth risks to the downside, especially near-term. Lagarde also noted that wages are boosting inflation across the forecast horizon as the labor market remains robust. Asked during the Q&A about future rate hikes, Lagarde was unequivocal by noting that it was obvious to expect more 50 bp hikes “for a period of time.” She stressed that market rate bets wouldn’t lead to inflation converging with the 2% target and that the ECB needs to do more than what the market expects. Lastly, Lagarde said that anyone who thinks the ECB is pivoting is wrong, as the bank wants rates at a sufficiently restrictive level to achieve its inflation target.

Reports suggest more than a third of the ECB policymakers favored a 75 bp hike yesterday. Sources said that the hawks settled for a smaller 50 bp move in return for more hawkish messaging on future hikes as well as a firm commitment to promptly start Quantitative Tightening. WIRP suggests a 50 bp hike February 2 is priced in, with 15% odds of a larger 75 bp move. Another 50 bp hike is 80% priced in for March 16, followed by a 25 bp hike either May 4 or June 15. There are some odds of a final 25 bp hike that takes the deposit rate up to 3.5%, up from 3.0% at the start of this week. On the other hand, the swaps market is now pricing in a peak near 3.75% vs. 3.0% at the start of this week.

Eurozone preliminary December PMIs were reported. Headline manufacturing PMI is expected to remain steady at 47.1, services PMI is expected to remain steady at 48.5, and the composite PMI is expected to rise two ticks to 48.0. Looking at the country breakdown, the German composite is expected to rise two ticks to 46.5 and the French composite is expected to remain steady at 48.7. Italy and Spain will be reported along with the final PMI readings in early January.

The U.K. reported weak November retail sales data. Headline sales came in at -0.4% m/m vs. 0.4% expected and a revised 0.9% (was 0.6%) in October, while sales ex-auto fuel came in at -0.3% m/m vs. 0.3% expected and a revised 0.7% (was 0.3%) in October. As a result, the y/y rates remain deeply negative at -5.9% for both measures of retail sales. December U.K. GfK consumer confidence came in at -42 vs. -43 expected and -44 in November, suggesting little relief to sales this month.

Elsewhere, U.K. preliminary December PMIs were mixed. Manufacturing PMI came in at 44.7 vs. 46.5 expected and actual in November, while services came in at 50.0 vs. 48.5 expected 48.8 in November. This dragged the composite up to 49.0 vs. 48.0 expected and 48.2 in November and is the highest since September. Despite the slight improvement here, it’s clear from other indicators that the U.K. economy is already in recession. The only question is how long and how deep. Much will depend on the weather and Bank of England policy, both of which are as unpredictable as ever.

Bank of England tightening expectations remain subdued. WIRP suggests a 50 bp hike February 2 is about 85% priced in, with no odds of a larger 75 bp hike. The swaps market back to pricing in a peak policy rate between 4.5-4.75% vs. 4.5% right after this week’s BOE decision but still down sharply from 6.25% right after the mini-budget in late September.

Russia central bank is expected to keep rates steady at 7.5%. The bank did the same at the last policy meeting October 28, the first hold after six straight cuts. Governor Nabiullina said then that the bank was sending a “neutral signal” and added that “Further trajectory will be data-dependent.” Since then, inflation eased to 12.63% y/y in October and is expected to fall further to 12.1% y/y in November. Meanwhile, the economy is getting hit hard by sanctions and so we see some risks of a dovish surprise this week.

ASIA

Japan reported mixed preliminary December PMIs. Manufacturing came in at 48.8 vs 49.0 in November while services came in at 51.7 vs. 50.3 in November. This dragged the composite up to 50.0 vs. 48.9 in November and reverses the sub-50 dip seen last month. That said, most of the recent data show the economy slowing in Q4, which should keep the Bank of Japan on hold for now. Next policy meeting is December 19-20 and no change is expected then. Markets will be keen to see if there is any mention of a policy review, which would suggest some sort of pivot is nearing.

On the other hand, Australia reported soft preliminary December PMIs. Manufacturing came in at 50.4 vs 51.3 in November while services came in at 46.9 vs. 47.6 in November. This dragged the composite down to 47.3 vs. 48.0 in November and is the lowest since January. The economy is likely feeling the chill from the slowdown in the mainland China economy. That said, WIRP suggests 55% odds of a 25 bp hike February 7, while the swaps market is pricing in a peak policy rate near 4.05% vs. 3.65% at the start of this week.

China announced the creation of a new state-owned company that will buy iron ore for its domestic steel companies. China Mineral Resources Group will likely become the world’s largest iron ore buyer next year when begins purchases on behalf of about 20 of the largest steelmakers in China. Reports suggest CMRG has already begun discussing supply contracts with top iron ore producers such as Rio Tinto, Vale. and BHP. The presence of a dominant single buyer of a good or service is identified in Economics 101 as a monopsony, as opposed to a dominant single seller of a good or service that is identified as the well-known monopoly. If memory serves, monopsony power will lead to lower prices and less sold than a competitive market solution and so the creation of CMRG bodes ill for iron ore sellers in Australia and Brazil. Reports suggest CMRG already plans to seek discounts to prevailing market prices. Stay tuned.

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