Knot Throws Euro a Lifeline

May 17, 2022

April retail sales data will be the highlight; Fed tightening expectations remain steady; regional Fed manufacturing surveys for May started rolling out

The euro is rallying on hawkish ECB comments; ECB tightening expectations remain subdued; eurozone data came in slightly better than expected; reports suggest the U.K. will lay out its plans to unilaterally change the Brexit trade deal; U.K. reported firm labor market data 

Japan’s cabinet approved a JPY2.7 trln ($21 bln) extra budget; RBA minutes were released

The dollar remains under pressure.  DXY is down for the third straight day and is trading near 103.536.  A break below 103.365 would set up a test of the May 5 low near 102.352.  We view this as a correction within the longer-term dollar rally.  The euro is trading at the highest level since May 12 near $1.0510 on hawkish ECB comments (see below).  A break above $1.0530 would set up a test of the May 5 high near $1.0640.  USD/JPY remains stuck near 129 despite the return of risk on sentiment but we continue to target the January 2002 high near 135.15 as risk sentiment improves.  Sterling is outperforming on strong data, trading at the highest level since May 5.  Clean break above $1.2455 sets up a test of the May 4 high near $1.2640.  EUR/GBP is lower despite negative Brexit news but we do not think sterling outperformance can be maintained.


April retail sales data will be the highlight.  Headline is expected at 1.0% m/m vs. 0.7% in March, while ex-auto is expected at 0.4% m/m vs. 1.4% in March.  The so-called control group used for GDP calculations is expected at 0.7% m/m vs. 0.7% in March.  We note that the retail sales data are not adjusted for inflation and so will be boosted in part by the 0.3% m/m gain in CPI that month.  Can consumption hold up in the face of rising inflation?  Given some recent weakness in the U.S. data, markets are growing increasingly concerned about the durability of the expansion here.  We remain constructive on the U.S. economy and believe recession fears are overblown at this time. 

Fed tightening expectations remain steady.  WIPR suggests 50 bp hikes in June, July, and September will be followed by 25 bp hike in November and December, which would see the Fed Funds rate peak near 3.0%.  The swaps market still sees a terminal Fed Funds rate near 3.0%, right where it started last week.  Bullard, Harker, Kashkari, Powell, Mester, and Evans all speak today.  Last week, Fed officials were uniformly hawkish and we expect a similar tone this week, especially in light of the April inflation data.  

Regional Fed manufacturing surveys for May started rolling out.  Empire survey came first and it was ugly.  Headline came in at -11.6 vs. 15.0 expected and 24.6 in April.  However, this series has been alternating between negative and positive readings since the year began and so we do not want to make too much of the weak May number.  Philly Fed will be reported Thursday and is expected at 16.5 vs. 17.6 in April.  March IP will also be reported today and is expected at 0.5% m/ vs. 0.9% in February.  The manufacturing sector continues to struggle with supply chain issues but we see underlying strength being maintained as we move towards H2.  March business inventories (1.9% m/m expected) will also be reported.


The euro is rallying on hawkish ECB comments.  Knot said he favors July liftoff and added that “Based on current knowledge, my preference would be to raise our policy rate by a quarter of a percentage point. Unless new incoming data in the next few months suggests that inflation is broadening further or accumulating. If that’s the case, a bigger increase must not be excluded either.”  He is one of the most hawkish on the Governing Council and so his comments shouldn’t be very surprising.  That said, the FX market is using his comments as an excuse to take the euro higher.  While a break above $1.0530 would set up a test of the May 5 high near $1.0640, we believe further gains will be limited.

ECB tightening expectations remain subdued.   Liftoff July 21 remains fully priced in.  However, the swaps market is pricing in only 150 bp of tightening over the next 12 months followed by another 40 bp of tightening priced in over the following 12 months that would see the deposit rate peak near 1.40% vs. 1.75% at the start of last week.   Centeno and Lagarde speak today, while the ECB releases its account of the April meeting Thursday.  While ECB officials have clearly pivoted more hawkish since that meeting, we do not believe that Knot speaks for the majority of the Governing Council and so we downplay talk of larger hikes.  

Eurozone data came in slightly better than expected.  Q1 GDP growth was revised up a tick from the flash reading to 0.3% q/q and 5.1% y/y, respectively.  We can’t get too excited about this, knowing that Q2 will likely see a significant slowdown.  Elsewhere, France reported Q1 unemployment down a tick to 7.1%, which like Germany matches the pre-pandemic low.  Of note, Italy and Spain have lagged as unemployment there still remains above pre-pandemic levels. 

Reports suggest the U.K. will lay out its plans to unilaterally change the Brexit trade deal.  Foreign Secretary Liz Truss is expected to make a statement today that sets out her plan to override parts of the Northern Ireland protocol if current talks with the EU fail to make progress.  While it’s easy to chalk this up to brinksmanship, we again note that the U.K. is playing a weak hand rather badly.  We continue to believe that if a trade war breaks out between the two, the U.K. stands to lose much more than the EU.  The U.K. is already facing recession risks from other headwinds, but a trade war would likely turn a mild recession into a deep one.  In addition, so-called equivalence for U.K. financial firms would be dead in the water.  

It’s hard to reconcile this news with the bounce in sterling.  While cable is benefitting from broad-based dollar weakness today, it’s the drop in the EUR/GBP cross that is most puzzling.  If the U.K. does follow through with its threats, we would expect the euro to greatly outperform sterling.  Even if the U.K. steps back from the brink, the outlook for the U.K. economy is much worse than it is for the eurozone.  As such, we would fade this move lower in EUR/GBP as it approaches the May 2 low near .8376.

U.K. reported firm labor market data.  For the three months ended in March, unemployment fell a tick to 3.7% and average weekly earnings picked up to 7.0% y/y vs. 5.4% expected and a revised 5.6% (was 5.4%) in February.  Jobless claims came in at -56.9k in April vs. a revised -81.6k (was -46.9k) in March, driven by a 121k rise in payrolled employees vs. a revised 59k (was 35k) in March.  April CPI data will be reported tomorrow.  Headline is expected at 9.1% y/y vs. 7.0% in March, core is expected at 6.2% y/y vs. 5.7% in March, and CPIH is expected at 7.9% y/y vs. 6.2% in March.   

Bank of England tightening expectations have stalled.  WIRP suggests another 25 bp hike is priced in for the next meeting June 16.  Looking ahead, the swaps market is still pricing in 150 bp of total tightening over the next 12 months that would see the policy rate peak near 2.50%, steady from the start of this week.  Cunliffe speaks today.  


Japan’s cabinet approved a JPY2.7 trln ($21 bln) extra budget to help households and firms hurt by inflation.  The budget is part of a package of measures announced by Prime Minister Kishida last month.  Finance Minister Suzuki said that “We’ll seek the passage of this budget in the current parliamentary session.  We’ll make efforts to quickly and appropriately enact the budget policies, while continuing to seek fiscal health.” Reports suggest it should pass easily.

RBA minutes were released.  At the May 3 meeting, the bank delivered a hawkish surprise with a 25 bp hike to 0.35% vs. 15 bp expected.  Minutes show that “Members agreed that the condition the Board had set to increase the cash rate had been met. They also agreed that further increases in interest rates would likely be required to ensure that inflation in Australia returns to the target over time.”  The bank discussed three options for hiking rates: “Members agreed that raising the cash rate by 15 bp was not the preferred option given that policy was very stimulatory and that it was highly probable that further rate rises would be required.  An argument for an increase of 40 bp could be made given the upside risks to inflation and the current very low level of interest rates. However, members agreed that the preferred option was 25 bp. A move of this size would help signal that the Board was now returning to normal operating procedures after the extraordinary period of the pandemic.”  WIRP suggests a 25 bp hike is fully priced in for the next meeting June 7.  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 3.35%.   

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