• Markets were buffeted overnight by renewed tensions in the Middle East; Fed officials have started to mention the possibility of hikes; Q1 growth remains robust; weekly jobless claims point to strength in the labor market
  
• U.K. reported soft March retail sales; S&P downgraded Israel a notch to A+ and maintained a negative outlook
  
• Japan reported softer March national CPI; MXN is the biggest casualty today

The dollar is trading flat as markets calm. DXY traded as high as 106.348 today on Middle East tensions (see below) but is now trading flat near 106.095. Looking through the noise, DXY remains on track to test the November 1 high near 107.113. The euro is trading flat near $1.0655 but the clean break below $1.0755 sets up a test of the November 1 low near $1.0515. Elsewhere, sterling is trading flat near $1.2440 despite weak retail sales data (see below). USD/JPY is trading flat near 154.55 and remains just below the new cycle high near 154.80 from Tuesday. The dollar rally should continue as recent data confirm persistent inflation and robust growth in the U.S. In turn, Chair Powell and other Fed officials have taken a much more hawkish turn (see below). This should keep upward pressure on U.S. yields. We believe that while market easing expectations have adjusted violently this month, there is still room to go. When the market finally capitulates on the Fed, the dollar should gain further.

AMERICAS

Markets were buffeted overnight by renewed tensions in the Middle East. Risk off sentiment swept through markets after U.S. officials confirmed Israel launched a retaliatory strike on Iran. USD, CHF, and JPY surged even as Brent oil rose back above $90 per barrel. Global equity markets sank while U.S. Treasuries were bid. However, most of these moves have since reversed as an uneasy calm has returned to the markets after reports that Iran told the United Nations that Iran is ready to de-escalate if Israel halts its “military adventurism.” Looking through the noise generated by these tensions, we believe the dollar uptrend remains intact. The fundamental backdrop of U.S economic outperformance coupled with hawkish Fed rhetoric remains in play.

Fed officials have started to mention the possibility of hikes. Williams said “Monetary policy is in a good place. We’ve got interest rates in a place that is moving us gradually to our goals, so I definitely don’t feel urgency to cut interest rates.” However, he added that while a rate hike is not his baseline view, it’s possible if the data warrant it. Bostic said “Right now, where our stance is - I think is a restrictive stance - it will slow the economy down and eventually get us to 2%. But I’m not in a mad-dash hurry to get there if all these other good things are happening.” He later said that if “inflation starts moving in the opposite direction away from our target, I don’t think we’ll have any other option but to respond to that. I’d have to be open to increasing rates.” Kashkari said, “I’m in the view of, we need to wait and see, be patient as long as it takes, until we get convinced that inflation is on its way back down to 2%” and added that rates could “potentially” be kept steady this year.

To be clear, a hike this year is unlikely. However, just the fact that Fed officials are acknowledging the possibility is a huge shift from its previous intent to begin cutting rates this year. If market pricing were to shift in favor of hikes, the impact on markets would be huge. Stay tuned. Goolsbee speaks today. At midnight tonight, the media blackout for the April 30-May 1 FOMC meeting begins and we will have no Fed speakers until Chair Powell’s post-decision press conference the afternoon of May 1. The market often softens its Fed outlook during this quiet period. However, the Fed is sending a very hawkish message and markets would do well not to forget that.

Q1 growth remains robust. Official data will be out next week with consensus currently at 2.3% SAAR. The New York Fed’s Nowcast model is tracking Q1 growth at 2.2% SAAR and Q2 growth at 2.6% SAAR and will be updated today. Elsewhere, the Atlanta Fed’s GDPNow model is tracking Q1 growth at 2.9% SAAR and will be updated next Wednesday after the data. We think this ongoing strength in the economy all boils down to the U.S. labor market. As long as jobs are being created, both consumption and growth will remain strong, and firms will be able to pass on higher costs to consumers. When all is said and done, we suspect the Fed will discover that disinflation may stall out without significant weakening of the labor market. Stay tuned.

Weekly jobless claims point to strength in the labor market. That’s because the initial claims reading will be for the BLS survey week containing the 12th of the month. These came in at 212k vs.215k expected and a revised 212k (was 211k) last week. Continuing claims are reported with a one-week lag, and these came in at 1.812 mln vs. 1.818 mln expected and a revised 1.810 mln (was 1.817 mln) last week. Bloomberg consensus for NFP just came out at 275k vs. 303k actual in March, while its whisper number stands at 230k.

EUROPE/MIDDLE EAST/AFRICA

U.K. reported soft March retail sales. Headline sales came in flat m/m vs. 0.3% expected and a revised 0.1% (was flat) in February, while sales ex-automotive came in at -0.3% m/m vs. 0.3% expected and a revised 0.3% (was 0.2%) in February. Both y/y rates still picked up to 0.8% and 0.4%. Going forward, consumer spending is expected to recover, underpinned in part by positive real wage growth. Until then, soft retail sales activity and high underlying inflation complicates the BOE’s task of achieving price stability and supporting growth. The first cut is around 80% priced in for August. Ramsden and Mann speak later today.

S&P downgraded Israel a notch to A+ and maintained a negative outlook. The agency noted that “The recent increase in confrontation with Iran heightens already elevated geopolitical risks for Israel.” Of note, the downgrade came before the attack on Iran and S&P said the rating will be reviewed again May 10. Back in February, Moody’s downgraded Israel a notch to A2 (equivalent to A).

ASIA

Japan reported softer March national CPI. Headline came in a tick lower than expected at 2.7% y/y vs. 2.8% in February, while core (ex-fresh food) came in a tick lower than expected at 2.6% y/y vs. 2.8% in February. Core ex-energy came in a tick lower than expected at 2.9% y/y vs. 3.2% in February. Reports have emerged suggesting the BOJ may raise its inflation forecast for FY2024 from 2.4% currently at the upcoming April 25-26 meeting. FY26 will be added to the forecast horizon and those reports also suggest the bank’s forecast will be around 2%. Of note, April Tokyo CPI will be reported next Friday, with core expected to slow further to 2.2% vs. 2.4% in March. The market is pricing in only around 50 bp of tightening over the next two years.

The Mexico peso is the biggest casualty today. USD/MXN traded as high as 18.2135 today, the highest since October and nearly testing that month’s high near 18.4665 before falling back to 17.3680 currently. Most EM currencies were hit hard by risk off sentiment, but positioning likely led the peso to experience an outsized reaction. MXN has been a favored carry trade this year, especially amongst Japanese retail investors. Positioning had become heavily skewed, leading to today’s flash crash during Asian hours. It is no longer the top performing EM currency YTD. We remain negative on EM, but the peso should continue to outperform within EM FX on solid fundamentals and high interest rates. However, today’s moves underscore just how dangerous the carry trade has become in a strong dollar, rising U.S. rate environment.