Euro Soft as ECB Debates Crisis Tool

June 29, 2022

Win Thin

U.S. yields are rangebound as markets try to assess recession risks; Fed officials remains hawkish; Fed tightening expectations have steadied but remain off the recent highs; regional Fed manufacturing surveys for June were uniformly weak; final Q1 GDP revision will be reported
Reports suggest the internal debate about the ECB crisis tool continues; June eurozone CPI readings take center stage; ECB tightening expectations have picked up slightly; Hungary delivered a hawkish surprise
Japan reported May retail sales and June consumer confidence; Australia reported strong May retail sales

The dollar is holding on to yesterday’s gains. DXY is trading flat near 104.50 after trading as low as 103.77 yesterday. The euro traded as low as $1.0485 today before rebounding back above $1.05. It remains heavy despite higher than expected inflation data out of Spain (see below). The weakening trend in the yen continues, with USD/JPY up for the fourth straight day and trading just below last week’s cycle high near 136.70. With BOJ dovishness being maintained, we still believe the pair will eventually test the August 1998 high near 147.65. Sterling continues to underperform and is trading near $1.2150. Break below $1.2115 would set up a test of the June 14 cycle low near $1.1935. When all is said and done, we believe the U.S. economy will prove to be more resilient than the rest of DM and so we look for continued dollar gains.

AMERICAS

U.S. yields are rangebound as markets try to assess recession risks. The 10-year yield traded as low as 3.00% Friday but ended the week near 3.13%. It is now trading near 3.16%, down from 3.25% yesterday. Similarly, the 2-year yield traded as low as 2.87% Friday but ended the week near 3.06%. It is now trading near 3.10%, down from 3.15% Monday. Both yields are well below the mid-June peaks near 3.50% and 3.45%, respectively.

Fed officials remains hawkish. Mester noted that the Fed is “just at the beginning” of its tightening cycle and added that she’d like to see the Fed Funds rate between 3.0-3.5% this year and “a little bit above 4%” next year. Mester acknowledged “There are risks of recession. We’re tightening monetary policy. My baseline forecast is for growth to be slower this year” but she does not forecast a recession. Bullard speaks today and he will continue to express support for a 75 bp hike next month. Fed Chair Powell also takes part in a panel discussion with Lagarde, Bailey, and Carstens at the ECB forum in Sintra.

Fed tightening expectations have steadied but remain off the recent highs. WIRP suggests a 75 bp hike at the next meeting July 27 is 55% priced in, down from 85% at the start of this week, while 50 bp hikes at the subsequent meetings September 21 and November 2 are almost fully priced in. Looking ahead, the swaps market is pricing in 200 bp of tightening over the next 12 months that would see the policy rate peak between 3.50-3.75%, down from nearly 4.0% at the start of last week.

Regional Fed manufacturing surveys for June were uniformly weak. Yesterday, Richmond Fed came in at -19 vs. -9 in May. Before that, Empire survey came in at -1.2 vs. -11.6 in May, Philly Fed came in at -3.3 vs. 2.6 in May, Kansas City came in at 12 vs. 23 in May, and Dallas came in at -17.7 vs. -7.3 in May. Manufacturing still seems to be suffering from supply chain issues but now has to contend with a possible slowdown in demand. Stay tuned.

Final Q1 GDP revision will be reported. Consensus sees growth steady at -1.5% SAAR. Yet with Q2 almost over, Q1 is ancient history. The Atlanta Fed’s GDPNow model is currently tracking 0.3% SAAR for Q2. It has been as high as 2.5% SAAR back in mid-May and as low as 0.0% SAAR in mid-June. Barring a miraculous recovery in the June data, Q2 GDP will come in quite weak. Bloomberg consensus currently sees 3.0% SAAR and that is clearly too high, while Q3 consensus is currently 2.4% SAAR and Q4 is 2.0% SAAR.

EUROPE/MIDDLE EAST/AFRICA

Reports suggest the internal debate about the ECB crisis tool continues. Newswire reports that officials are weighing whether to announce the size and duration of the program. ECB staff is apparently preparing several different options for the Governing Council to consider, including which details should be made public. We see two positive options and two negative ones. On the positive side, 1) Madame Lagarde could have an open-ended “whatever it takes” moment that is short on specifics but makes clear that the ECB will intervene massively if needed. Or 2) the ECB could announce an aggressive program with a sufficiently large bazooka that deters markets from testing it. On the negative side, the ECB could 3) announce another small tweak (a la adjusting reinvestment proceeds) or perhaps 4) even delay any announcement altogether because the GC cannot agree on a comprehensive plan. Faithful readers know that we are expecting the ECB to disappoint once again, with option 3 the most likely outcome.

June eurozone CPI readings take center stage. Spain reported EU Harmonized inflation at a whopping 10.0% y/y vs. 8.7% expected and 8.5% in May. Germany reports later today and is expected at 8.8% y/y vs. 8.7% in May. However, German state data already reported today suggest downside risks to the national reading. France reports tomorrow and its EU Harmonized inflation is expected at 6.5% y/y vs. 5.8% in May. Italy reports Friday and its EU Harmonized inflation is expected at 7.9% y/y vs. 7.3% in May. Eurozone also reports CPI Friday. Headline is expected at 8.5% y/y vvs.8.1% in May, while core is expected at 3.9% y/y vs. 3.8% in May.

ECB tightening expectations have picked up slightly. WIRP suggests a 25 bp hike July 21 is still fully priced in. Despite the hawks pushing for a 50 bp liftoff, market pricing hasn’t budged. Then, 50 bp hikes are no longer fully priced in for the subsequent three meetings on September 8, October 27, and December 15 and so the deposit rate is seen near 1.0% at year-end vs. 1.25% at the start of last week. Looking ahead, the swaps market is pricing in 250-275 bp of tightening over the next 24 months that would see the deposit rate peak between 2.0-2.25% vs. 1.75-2.0% at the start of this week. Of note, eurozone May M3 growth slowed to 5.6% y/y vs. 5.8% expected and a revised 6.1% (was 6.0%) in April. This was the slowest since February 2020 and so the impact of the ECB’s pandemic-related stimulus has basically worn off even before the bank starts removing accommodation.

National Bank of Hungary delivered a hawkish surprise. It hiked rates a whopping 185 bp to 7.75% vs. 50 bp expected. The bank said it will hike its 1-week deposit rate 50 bp to 7.75% at its weekly tender tomorrow to match the base rate. However, Deputy Governor Virag said he could not rule out the 1-week rate rising above the base rate in the future if necessary. Virag also said the bank will continue hiking until inflation peaks but warned of double digit reading . CPI rose 10.7% y/y in May, the highest since May 2001 and further above the 2-4% target range. The swaps market is pricing in 175 bp of tightening over the next 6 months that would see the base rate peak near 9.5% but we see clear upside risks as price pressures continue to climb.

ASIA

Japan reported May retail sales and June consumer confidence. Sales came in at 0.6% m/m vs. 1.0% expected and 1.0% in April, while the y/y rate came in at 3.6% vs. 4.0% expected and 3.1% in April. Elsewhere, consumer confidence fell to 32.1 vs. 34.8 expected and 34.1 in May. This was the lowest since January 2021 and yet consumption continues to recover from the reopening of the economy. Still, we are seeing some divergence with the production side as IP has been contracting in recent months. May IP will be reported tomorrow and is expected to recover to 4.2% y/y vs. -4.9% in April.

Australia reported strong May retail sales. Sales rose 0.9% m/m vs. 0.4% expected and 0.9% in April. This pushed the y/y rate up to 10.4% vs. 9.6% in April, the strongest since April 2021 and despite high base effects. Of note, the RBA started its tightening cycle on May 3 with a 25 bp hike and so households were starting to see the impact of higher rates. With consumption remaining strong, the RBA should continue hiking rates aggressively. WIRP suggests nearly 66% odds of a 50 bp hike at the next meeting July 5. Looking ahead, the swaps market is pricing in 300 bp of tightening over the next 12 months that would see the policy rate peak near 4.0%.

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