by Marc Chandler
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As the month and quarter wind down, inflation readings are featured. The US May PCE deflator, which is the targeted measure is reported. Canada and Australia report May CPI. The eurozone reports the preliminary June CPI, and Japan see Tokyo's June CPI, which serves a similar function. Leaving aside Japan, the others, including the UK have signaled that the monetary tightening cycle will be extended into H2. That said, the poor preliminary PMI readings fan ideas poor growth will curtail the monetary tightening cycle. While possible, we are more persuaded that many central banks will risk a recession to bring inflation down. In the week ahead, Sweden's Riksbank may slow to a quarter point hike after lifting the repo rate twice this year by 50 bp and hiking by 175 bp in H2 22.
The market has been skeptical of the Fed's hawkishness and as recently as a month ago was discounting cuts before the end of this year. It has come around begrudgingly but has not taken the updated projections that see two more hikes this year as appropriate very seriously. The implied year-end effective rate in the futures market is seen near 5.24% compared with the current 5.07-8% (the weighted average of Fed funds transactions since the May hike). This translates into an almost 60% chance of one hike. We look for the market to move toward the Fed (again), perhaps helped by another sticky core PCE deflator, which is seeing little improvement. This adjustment may help the dollar extended its recovery.
United States: House prices, new home sales, and revision to Q1 GDP are on tap next week, but the main interest will be the personal income, consumption, and deflators. Personal consumption in nominal terms rose at a blistering pace of nearly 9% in the first four months of the year. But in real terms, it was nothing to sneeze at, 4.8%. However, the pace is set to moderate. The median forecast in Bloomberg's survey looks for a 0.2% gain in May, which is flat in real terms. Weaker demand seems to be the key objective of Fed policy as it can do little for supply. The resumption of student loan servicing in October is seen as a factor that will likely weaken demand starting as early as next quarter. Personal income as averaged a 0.4% gain this year, a little better than the first four months of 2022.
On the way up, Fed Chair Powell often cited headline CPI. On the way down, he seems to spend more time talking about the core PCE deflator. Although the Fed targets the headline PCE deflator, Powell recognizes that the core rate is a better signal of where the headline is going. The median forecast in Bloomberg's survey for the PCE deflator is for a 0.1% gain. If that is accurate, it would mean that the pace of inflation in first five months of the year is nearly half of what it was in the first five months of 2022 (3.6% vs. 7.0%). The core pace, as is widely recognized, is proving more buoyant. The median forecast in Bloomberg's survey is for a 0.4% rise the core rate. Assuming that is accurate, the annualized pace through May would be slightly higher than the Jan-May period last year (~4.8% vs. 4.6%).
The Dollar Index slipped below 102.00 on June 22 to make a new one-month low but recovered smartly ahead of the weekend to approach the (50%) retracement of the leg down since the May 31 high near 104.70. That retracement objective and the 20-day moving average are around 103.30. Above there, the next important chart is 103.65-75. It holds the next retracement, the 20-day moving average and the measuring objective of a possible double bottom. The momentum indicators have also turned up.
Eurozone: There are two big items on the eurozone agenda next week. First, the preliminary June CPI will be reported at the end the week. It will be difficult to do better than the May's flat report. Even though the euro appreciated, energy prices rose. In June 2022, CPI rose by 0.8%. The favorable base effect suggests continued downward pressure on the year-over-year rate. The year-over-year rate peaked last October at 10.7%. It stood at 6.1% in May, and many have fallen toward 5.5%-5.6% this month. A 0.2% increase that the median forecast in Bloomberg's survey projects would mean that H1 inflation rose at an annualized rate of 4.6%. That is 100 bp above the annualized rate through May of the US PCE deflator that we noted above. Eurozone improvement is likely to stall next month but a rate hike at the July 27 meeting is nearly assured (90% confidence in the swaps market). The fight is not so much over the July move but the one after that. The swaps market is fairly confident of a hike in Q4, though it will be tested in September and October when the 12-month comparison will fall sharply as the 1.2% and 1.4% increases from last September and October, respectively, are dropped. Separately, the core rate is sticky. It peaked in March at 5.7% year-over-year.
Second, there are almost 477 bln euros in ECB loans (Targets Long-Term Refinancing Operations, TLTROs) that come due. We suspect that banks have secured alternative funding, but it does mean a large decline in the ECB's balance sheet. The market has seen this before (e.g., in March and last November and December). Still, it represents around 6% of the ECB balance sheet and nearly 45% of the outstanding TLTROs. Through the middle of June, the ECB's balance sheet has been reduced by about 13%. By comparison, the Fed's balance sheet has been reduced by a little more than 6% since last year’s peak. As an aside, the lending rather than buying to expand the central bank's balance sheet when the zero-bound is approached seems like among the more successful tools that have emerged from the Great Financial Crisis and the response to the pandemic.
The euro briefly traded above $1.10 on June 22, its best level since May 8. It reversed lower and the poor PMI ahead of the weekend drove it to around $1.0845. The (50%) retracement of the euro's ascent from the May 31 low (~$1.0635) is around $1.0825 and the 20-day moving average is slightly below $1.0810. The momentum indicators are over-extended but have yet to turn down. The risk is that the correction could carry the euro toward $1.0725. Technically, we should be prepared for a three-leg down move. If the first leg was seen at the end of last week, the second leg higher may be capped in the 1.0900-20 area.
Japan: In the first half of the 2023, Japan is set to be one of the fastest if not the fastest growing economy in the G10. Japan reports retail sales, industrial production, and employment figures in the week ahead. Retail sales rose by an average of 0.5% a month in the first four months of the year, a little more than twice the pace seen in the year ago period. However, they fell by 1.1% in April and are expected to have recovered in May. Industrial output has risen by an average of 0.2% in the January-April period. It was flat in the first four months of 2022. Unemployment was at 2.6% in April. The cyclical low was 2.4% and the jobs-to-applicant ratio, which had trended higher, has leveled off this year. The most important high-frequency data point is the Tokyo's June CPI. Inflation in the capital does a good job tracking the national figures, which come with a several week lag. Although the national figure is due before the Bank of Japan meets in late next month, Tokyo's July CPI will not be released until after the meeting, which will see updated forecasts. The risk is on the upside of the measure that excludes fresh food and energy from 3.9% year-over-year pace in May.
The monetary policy divergence sent the yen to new lows for the year against the dollar last week and new multi-year lows against the euro and sterling. It has fallen to record lows against the Swiss franc. The yen is used as the short leg of cross positions and as the long leg, like the euro, sterling, and the Australian dollar are liquidated, the short leg is covered. This may help slow the yen's descent against the dollar. The momentum indicators are stretched but have not turned down and the dollar finished above the upper Bollinger Band (~JPY143.20) for the second straight session. The next target we suggested is in the JPY145-146 area.
China: Market participants may talk about the PMI, but it does not matter in the immediate context. Officials have already decided the economy needs more support. Investors are waiting for the government's stimulus measures to be announced but seem to be exaggerating the weakness of the economy. China's economy grew by 2.2% quarter-over-quarter in Q1, a good down payment toward the "about 5% target. The median forecast in Bloomberg's survey sees the world's second-largest economy expanding by 1.1% in Q2. Officials are not panicking, and the measures will likely be targeted toward technology areas that are being impinged by US efforts and the property market.
The mainland market was on holiday for the last two sessions. The dollar settled slightly below CNY7.18 last Wednesday. Against the offshore yuan, the dollar finished then close to CNH7.1770. However, while onshore market was closed, the offshore yuan continued to weaken. The greenback reached CNH7.2285 before the weekend and pulled back toward CNH7.20 as the dollar stabilized in North America. With the broad dollar gains, we see little to stop it from testing last year's high near CNY7.3275.
UK: The Bank of England delivered a 50 bp hike, getting ahead of expectations. The swap market is pricing in about a 75% chance of another 50 bp hike next month (August 3). There are four meetings left in the year and the market has the base rate rising 100 bp to 6% by the end of the year. Because inflation is so high and stubborn, after all the BOE began hiking rates earlier (December 2021) than most G10 countries, the upcoming data does not matter. Rates are going higher, and weak economic data will not prevent it and is the desired outcome. Indeed, it may be the case that strong economic data is seen by investors as bad news because it is consistent with more hikes and greater risk of a recession. The May consumer credit report on June 29 could test the hypothesis. Consider, consumer credit growth in March and April (~ GBP3.2 bln) was the most for a two-month period since April-May 2018. The was the debt and currency markets response could be revealing.
Sterling faltered on June 22 after the BOE's 50 bp hike, as it approached the 14-month high set on June 16 near $1.2850. It settled near $1.2750 and fell to nearly $1.2685 ahead of the weekend. The (38.2%) retracement objective of the rally since the May 5 low (~$1.2370) is around $1.2665. The $1.2600-10 area was the high set in May and finds the next retracement target (50%) and the 20-day moving average, which sterling has not closed below since June 6. The momentum indicators are turning lower. Initial resistance may be seen near $1.2750.
Canada: The strength of the Canadian economy has spurred a change at the Bank of Canada and the investors. Canada's two-year yield rose to around 4.70% last week, its highest since 2007, representing a more than 100 bp increase since the mid-May lows. May CPI will be reported June 27. Through April, it is rising at a 6.3% annualized rate, which might help explain the Bank of Canada's hawkishness amid signs that the economy remains resilient. Still, a large decline in the 4.4% year-over-year rate should be expected as last May's 1.4% increase drops out of the 12-month comparison. The Bank of Canada drew attention it its underlying inflation measures. The median and trim year-over-year measures are both at 4.2% and have been falling for five months through April. Canada's also reports April GDP (June 30) and after the stronger than expected retail sales reported last week (1.1% vs. 0.4%) suggest the economy bounced back after stagnating in March.
The US dollar fell from CAD1.3650 on May 31 to six-month lows on June 22 near CAD1.3140. The momentum indicators are over-sold, and the US dollar recovered to CAD1.3225 ahead of the weekend. Last week's high was near CAD1.3270 and this may offer nearby resistance, but there may be potential back toward CAD1.3335-50. That corresponds to the (38.2%) retracement of the decline here in June and the 20-day moving average, which it has not closed above this month. An important implication is that the Canadian dollar is trading less like a risk asset. The correlation between changes in the exchange rate and the S&P 500 over the past 30 days is the lowest of the year (0.33) and the correlation with Dollar Index is near the highest of the year (0.69). The correlation with changes in WTI steady (~0.55).
Australia: The combination of the RBA minutes and the disappointing flash PMI saw the market downgrade the chances of a hike at the July 4th meeting. The futures market has about less than a 30% chance compared around 55% a week ago. The May CPI report and retail sales report (June 28 and June 29, respectively) may support our view. Recall that CPI reaccelerated in April to a 6.8% year-over-year rate after reaching 6.3% in March. In April 2022, CPI rose 5.5% over the previous 12 months. Retail sales stagnated in April, and the strength of the May jobs growth hints at an increase in retail sales.
The Australian dollar was turned back from $0.6900 on June 16 and tumbled to almost $0.6660 before the weekend. It surpassed the (50%) retracement objective of this month's rally ($0.6680) and closed last week below the 20- and 200-day moving averages. The next retracement target (61.8%) is near $0.6625. The momentum indicators turned down and the risk is of a deeper pullback. One source of pressure on the Aussie may come from unwinding long positions against the New Zealand dollar. The Australian dollar rallied nearly 4.7% against the Kiwi from the year's low set on May 22 (NZD1.0560) to around NZD1.1055 on June 16. It tested the 200-day moving average and approached the (38.2%) retracement objective ahead of the weekend (~NZD1.0865-75). The next important chart area is around NZD1.08, but there may be potential toward the NZD1.07 area.
Mexico: Last week, the central banks of Chile, Brazil and Mexico did not change their policy rates. Chile and Brazil seem likely to be a little ahead of Mexico as candidates to cut rates in Q3 rather than Q4, which is when Banxico seems to signal. While headline and core prices rose less than expected in the first half of June, allowing the year-over-year rates to continue to decline. The central bank wants to get closer its target of 3% (+/-1%) before cutting. Mexico reports May's trade balance on June 27. The average deficit this year running slightly below last year's pace (-1.58 bln vs. -$1.64 bln). The trade report does not pose much of a risk to the peso, but what does too much of the favorable backdrop. The carry-trade and near-shoring meme have seem well known and appreciated, leaving to overweight positions. And performance is often chased. This could have been said in a few weeks ago too, of course. However, with respect to the price action, the momentum indicators are turning up, suggesting a scope for a proper correction. Here in Q2, counter-trend dollar rallies have held to about half of a peso. We anticipate that the one that appears to have begun can be somewhat more. The first hurdle may be near the 20-day moving average (~MXN17.3265), which the dollar has not closed above since May 25. Then is there is the MXN17.45-50 resistance area. If this can overcome, it could spur a deeper correction toward MXN17.90-MXN18.00.
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