Markets Boost Fed Easing Bets

• US interest rate expectations slide overnight, undermining the dollar and Treasury yields but supporting equity markets.

• ECB delivered on expectations and offered no new forward-looking policy hints.

• Peru’s central bank cuts the policy rate 25bps to 5.25% but cautioned against successive interest rate cuts.

USD is down against most major currencies and trading near a one week low as US interest rate expectations adjusted sharply lower overnight. Odds of a 50bps Fed funds rate cut next week rose from about 10% to over 40% while December 2024 Fed funds futures dropped from -106bps to a multi-month low at -117bps implying greater probability of five rate cuts by year-end.

There was no fundamental data trigger behind the move lower in US interest rate expectations. Yesterday’s US August PPI print was largely in line with consensus and does not move the Fed policy needle. Instead, the downward adjustment to US interest rate expectations may have been sparked by a Wall Street Journal report arguing for a dovish Fed policy rate cut at the September 18 meeting.

We maintain our dollar bullish view that the Fed is unlikely to slash rates as aggressively as implied by the money market. First, the US labor market is not falling out of bed. Second, US consumer spending is resilient. Third, underlying inflation is sticky. Fourth, financial conditions are loose.

Today, the University of Michigan preliminary September consumer sentiment report is expected to remain consistent with healthy US consumer spending activity (3:00pm London). Headline is projected to improve to a four-month high at 68.5 vs. 67.9 in August. Strong household balance sheet also supports solid consumption growth. Net worth-to-disposable personal income ratio rose to 785% of GDP in Q2 vs. 778% of GDP in Q1 to be just under its all-time high at 835% of GDP in Q1 2022.

EUR/USD is up almost 1% from yesterday’s low supported by widening Eurozone-US bond yield spreads. EU-US 2-year government bond yield spreads are near the highest level since May 2023. Yesterday, the ECB delivered on expectations and offered no new forward-looking policy hints:

(i) ECB cut the key deposit facility rate (DFR) 25bps to 3.50%. The ECB also slashed the rates on the main refinancing operations (MRO) and marginal lending facility (MLF) by 60bps to 3.65% and 3.90%, respectively. The aim is to improve liquidity condition and steer short-term money market rates closer to the DFR.

(ii) ECB maintained its cautious easing guidance. ECB reiterates that “it will keep policy rates sufficiently restrictive for as long as necessary” and “follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction.”

(iii) ECB made minor tweaks to inflation and real GDP growth forecasts. Headline CPI inflation forecast was unchanged. Core inflation projections for 2024 and 2025 were revised one tick higher but the ECB still expects it to reach 2% in 2026. Real GDP growth projections were revised one tick lower across the forecast horizon.

Regardless, the bar for additional ECB easing remains low and an important headwind for EUR. ECB President Christine Lagarde confirmed the decision to cut the deposit facility rate was unanimous. Recall, at the June 6 meeting one ECB governing council member (Robert Holzmann) objected to a cut. Lagarde also warned again that risks to economic growth are tilted to the downside.

Moreover, ECB Governing Council member Gediminas Simkus noted this morning that Eurozone inflation is “calming down” and “its trajectory suggests that further rate cuts must happen.” ECB Governing Council member Joachim Nagel added “the inflation outlook is very good”, implying more rate cuts in the pipeline.

Eurozone July industrial production is reported today (10:00am London) and there’s a couple of ECB speakers on the roster; Olli Rehn (9:30am London) and Christine Lagarde (10:30am London).

GBP is firmer versus USD and EUR. The Bank of England’s (BOE) quarterly inflation attitudes survey for August is reported today (9:30am London). Inflation expectations continue to fall across the spectrum, albeit slowly. As such, this should reinforce the BOE’s cautious approach to easing and underpin the uptrend in GBP versus EUR. The swaps market continues to imply about 50bps of BOE rate cuts by year-end, which seems about right.

Peru’s central bank delivered on expectations and cut the policy rate 25bps to 5.25%. The bank cautioned that “this decision does not necessarily imply successive interest rate cuts.” However, more cuts may be in the pipeline as headline inflation is at the mid-point of the 1-3% target range. PEN is the top performing currency in Latin America year-to-date. Peru’s positive real policy rate and a current account surplus on top of net FDI inflows should continue to support PEN’s regional outperformance.