Rates are moving in favor of the dollar; the rise in short-end U.S. yields reflects heightened Fed tightening expectations; the heavy slate of U.S. Treasury issuance concludes; Peru is expected to hike rates 50 bp to 5.5%.
The ECB is widely expected to keep rates steady whilst setting the table for July liftoff; the ECB could announce some details of a new emergency bond-buying program; new macro forecasts will be released; the euro has a mixed record on ECB decision days
Japan reported solid May machine tool orders; the RBNZ laid out details for planned Quantitative Tightening; China reported firm May trade data
The dollar is modestly weaker ahead of the ECB decision. DXY is trading near 102.40 and continues a pattern of alternating up/down days since the week began. The euro is trading back above $1.07 ahead of the ECB decision (see below). While a hawkish surprise could see a test of $1.08, we believe upside is limited. At some point, we think the weak eurozone outlook will outweigh the hawkish ECB. The weakening trend in the yen has stalled as USD/JPY made a marginal new high near 134.55 before reversing lower to trade near 133.20. We maintain our long-standing target of the January 2002 high near 135.15 but we need to start talking about the August 1998 high near 147.65. Sterling remains soft near $1.2535 after failing to break above $1.26. We still view the May move lower in the dollar as a correction within the longer-term dollar rally and are heartened by the recent bounce in June. That said, we acknowledge that further gains will likely be slow until the market pessimism on the U.S. economic outlook improves further.
AMERICAS
Rates are moving in favor of the dollar. The 2-year yield is trading near 2.78% today, up from last month’s low near 2.44% and nearing the May 4 peak near 2.85%. The 2-year differential with Germany has risen to 209 bp after briefly touching 200 bp earlier this week, the lowest since the end of February, while the gap with Japan has risen to a new cycle high near 285 bp. Much of this divergence hinges on the underlying relative monetary policy divergences as the ECB pivots more hawkish and the BOJ remains ultra-dovish. However, we believe the U.S. economy is set to outperform within DM and so the Fed will eventually out-hawk them all. We believe the dollar uptrend remains intact. Weekly jobless claims and Q1 household net worth will be reported.
The rise in short-end U.S. yields reflects heightened Fed tightening expectations. WIRP suggests 50 bp is fully priced in for June 15 and July 27. A third 50 bp hike for September 21 is now about 85% priced in vs. 75% at the start of this week and 35% at the start of last week. After that, three more 25 bp hikes in November, December, and February are fully priced in. Last week, the odds of a February hike were only around 25%. Looking ahead, the swaps market is now pricing in a terminal Fed Funds rate above 3.25% by mid-2023. We reiterate our call for a terminal rate of 3.5% (or higher).
The heavy slate of U.S. Treasury issuance concludes. $19 bln of 30-year bonds will be sold today. At the last auction, indirect bidders took 69.7% while the bid/cover ratio was 2.38. Yesterday’s $33 bln of 10-year notes saw weak demand, as indirect bidders took 63.6% vs. 70.3% previously and the bid/cover ratio was 2.41 vs. 2.49 previously. This saw the high yield rise to 3.03% v. 2.943% previously. This followed an equally weak $44 bln sale of 3-year notes Tuesday, when indirect bidders took 51.5% vs. 62.0% previously and the bid/cover ratio was 2.45 vs. 2.59 previously. This saw the high yield rise to 2.927% vs. 2.809% previously.
Peru central bank is expected to hike rates 50 bp to 5.5%. May CPI inflation came in at 8.09% y/y vs. 7.96% in April, the highest since May 1998 and further above the 1-3% target range. The central bank has been hiking rates at 50 bp clips all year and this is expected to continue for the time being.
EUROPE/MIDDLE EAST/AFRICA
The European Central Bank is widely expected to keep rates steady whilst setting the table for July liftoff. There has been some chatter about a surprise rate hike but most (including us) see this as highly unlikely. Even the hawks have coalesced around July 21 liftoff, though they continue to play up the need for a 50 bp move. We think a larger move is unlikely, at least for now. Madame Lagarde’s press conference will be key to setting market expectations. That said, ECB tightening expectations have picked up in light of last week’s inflation data. WIRP suggests liftoff July 21 remains fully priced in. However, markets are now pricing in a potential 50 bp move at either the September 8 or October 27 meetings, followed by a 25 bp hike December 15 that would take the policy rate to 0.75% by year-end, up from 0.5% previously. Looking ahead, the swaps market is pricing in 225 bp of tightening over the next 24 months that would see the deposit rate peak near 1.75% vs. 1.50% at the start of last week.
The ECB could announce some details of a new emergency bond-buying program. This plan was previously reported back in April, but more recent reports suggest ECB policymakers will ask President Lagarde to use stronger language today to signal that so-called fragmentation will be resisted and that any rise in peripheral borrowing costs will be contained. This would be a far cry from one of her earliest pronouncements back in March 2020 that “We are not here to close spreads.” It’s not clear if a concrete plan will be announced now but the timing would be ideal since the bank is widely expected to announce an end to QE today. Of note, the ECB has signaled that Quantitative Tightening is a 2023 (or beyond) story, making it much less aggressive than the Fed. The ECB needs to tread carefully here as the last thing the eurozone needs is some sort of taper tantrum just as the economic outlook is dimming.
New macro forecasts will be released. When the last forecasts were made in March, the full impact of the Ukraine crisis was largely unknown. While the situation is still unfolding, it’s clear that the impact on growth and inflation will be significant and the ECB will have to acknowledge this. Of note, the OECD just released its updated forecasts for the eurozone. The growth forecasts for 2022 and 2023 are 2.6% and 1.6% while the inflation forecasts are 7.0% and 4.6%, respectively. We expect the ECB forecasts to hew closely to the OECD’s, which would mark significant changes from these March forecasts.
The euro has a mixed record on ECB decision days. It has weakened the past two but before that had strengthened for four straight. Maybe the euro gets through $1.08 on a hawkish ECB surprise but further upside seems limited and we think it will eventually test this year’s low near $1.0350 and below. German data continues to roll over just as the ECB starts hiking. Sound familiar? At some point, we think the weak eurozone outlook will outweigh the hawkish ECB.
ASIA
Japan reported solid May machine tool orders. Orders rose 23.7% y/y vs. 25.0% in April. While the growth rate remains solid, it continues the slowing trend seen since the 2021 peak. Policymakers are well aware of the risks to the economic outlook and have shown no inclination to remove stimulus for the foreseeable future. The weak yen is a double-edged sword for Japan Inc. While it helps exports compete, it also leads to higher costs of imported raw materials. According to a survey conducted by the Japan Association of Corporate Executives, 74% of Japan’s top business managers say the weak yen is having a negative impact on the economy. Just over 30% said the weak yen is eroding earnings, while 26% said it’s boosting profits. The poll was conducted May 23-June 1 and the results are based on 197 responses, with 52 from manufacturing and the rest from services.
The RBNZ laid out details for planned Quantitative Tightening. Starting next month, the bank will sell its holdings back to the Treasury Department’s debt management office at a rate of NZD5 bln ($3.2 bln) per fiscal year. It said the sales would continue in a “gradual and predictable manner” until its holdings have reduced to zero, which it expects by mid-2027. Securities will be sold by maturity, beginning with those with the longest duration. Shorter-maturities will simply be allowed to mature without reinvestment or sales. Local yields jumped after the statement but this may have just been the knee-jerk reaction since the RBNZ will be selling the securities back to the issuer and not to the market. Either way, another chapter in the normalization of global monetary policy begins. As expected, the RBNZ is following the Fed’s playbook of starting QT only after several rate hikes have been seen. Next RBNZ meeting is July 13 and another 50 bp hike to 2.5% is priced in. Of note, the Fed will begin its QT June 15.
China reported firm May trade data. Exports rose 16.9% y/y vs. 8.0% expected and 3.9% in April, while imports rose 4.1% y/y vs. 2.8% expected and 0.0% in April. While the rebound is welcome news, it’s not all smooth sailing ahead as one area of Shanghai will be locked down Saturday to conduct a mass testing drive. While the plan is to quickly reopen, the risk is that any confirmed cases will lead to an extended two-week lockdown. Elsewhere, other parts of Shanghai are already back in lockdown to contain new outbreaks. Of note, Vice Commerce Minister Wang warned of several risks to trade, including a fragile global economy, high inflation everywhere, and supply bottlenecks within China. We concur.
