Prospects of Aggressive Tightening Sends Shock Waves through the Capital Markets

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Marc Chandler
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Overview: The markets' evolving expectations of a more aggressive monetary policy is not limited to the Federal Reserve, where the terminal rate is now straddling the 4% area, around 100 bp above late May levels. Consider that on May 31, the swaps market saw the key rate in the eurozone finishing the year at 60 bp. It has risen by more than 40 bp in the past four sessions. The UK expectedly reported the second consecutive monthly contraction in GDP, and still there was an 11 bp rise in the expected year-end rate to bring the five-day surge to more than 50 bp. This has seen equities plummet. The S&P 500 and NASDAQ gapped lower to new lows for the year. It was the second consecutive gap and lower opening, but there does not look to be a third. Equities were still heavy in the Asia Pacific region. Of the large markets, only China rose. Australia’s benchmark wilted by 3.5% to lead the drop. Europe’s Stoxx 600 is off around 0.5% near midday, falling for the sixth session. US futures, though, are pointing to a modestly higher open. The US Treasury market is better bid today and the 10-year yield is off five basis points to 3.30%. European yields are mostly 1-2 bp higher, though the yield on the 10-year Gilt comes off a little more than five basis points. The US and UK two-year yields are off 8-9 bp. The dollar is mixed. The euro, Swiss franc, and Japanese yen have advanced, while the dollar-bloc, sterling, and Norway are weaker. Among emerging markets, most currencies are firmer but a handful of East Asian currencies and the Mexican peso. Gold extended its sell-off to $1810 today after a big outside down day yesterday that peaked above $1878. It has steadied around $1823 now. July WTI is firm, holding above $120 and trading near $122. US natgas is up about 0.75% today after falling by about 4% over the past two sessions. Europe’s natgas benchmark is up 4.4% after a 1.4% gain yesterday. The new Covid restrictions in China continue to weigh on iron ore prices. They fell 1.1%, the fourth consecutive decline after a 3.65% drop yesterday. July copper is also off for the fourth session. July wheat is trading near the lows for the month, slipping 1.4% today after a steady session yesterday. 

Asia Pacific

The dramatic rise in US and European rates is encouraging market participants to challenge the Bank of Japan's commitment to the 0.25% cap on the 10-year yield. The challenge in April was turned back with the help of the 50 bp pullback in the US 10-year yield (from 3.20% on May 9 to almost 2.70% on May 26). BOJ Governor Kuroda is in a delicate position. Altering courses when under pressure carries added risks. Even if he wanted to raise the cap or abandon it altogether, it risks destabilizing the situation even further and adding to the volatility rather than reducing it. Many observers think the yen would be stronger if Japan's 10-year were to be allowed to rise. However, a decision to allow the yield to rise may not be decisive. The 30-year yield is set in the market. The yield is a little less than 1.2%. If the cap were abandoned the yield would rise and could squeeze some positions. A 50-75 bp rise in the 10-year yield would bring the spread with the US back to levels seen in late May. The funding role for the yen would likely be reset. 

Rising global rates not only challenge the BOJ's efforts to cap the 10-year yield, but it is also weighing on the yen. To combat the former, the BOJ is buying an increased amount of bonds, i.e., expand its balance sheets, which adds to the divergence that is driving the markets in the first instance. Earlier today, the BOJ bought JPY2.2 trillion of government bonds through its fixed-rate operation, a record amount in in six-year-old facility, and it bought JPY800 bln (instead of previously announced JPY500 bln of 5–10-year bonds under it outright purchases. For tomorrow, it has expanded it outright with JGB buying across five different buckets of maturities. This includes buying of the long end of the curve, which has come under more pressure too. In turn, this underscores a major argument against material invention. It is contrary to the thrust of policy. Intervention is an escalation ladder. The verbal intervention is working. There is no immediate need to take climb another step. Consider that over six sessions counting today, in the face of a broad-based dollar rally, the yen has fallen the least of the majors. It was fallen by about 1.7%.

Japanese officials have expressed concern about the pace of the yen's descent. Consider that the settlements over the last four sessions. It has been confined to JPY134.25-JPY134.45 range. The point is that the dollar is consolidating, and the lower end of the congestion is around JPY133.20. The dollar has been confined to yesterday's range (~JPY133.60-JPY135.20) but has not been above JPY135.00. The Australian dollar plunged to almost $0.6910 yesterday, its lowest level in nearly a month. It has stabilized today but the upticks were limited to the $0.6970 area. A move above $0.7000, and probably $0.7040 is needed to stabilize the technical tone. The low seen last month was closer to $0.6830, and a retest still must be favored. The US dollar closed yesterday's downside gap against the Chinese yuan by pulling back to last Friday's high (~CNY6.7170). It found support near CNY6.7135 before returning to almost CNY6.74. The dollar's reference rate was set at CNY6.7482, a pip above the median projection (Bloomberg survey). The greenback is slipping against the yuan today after a five-day advance. Separately, the PBOC announced that the foreign exchange on its balance sheet fell by CNY9 bln after falling CNY16.6 bln in April. In Q1, its fx holdings rose by about CNY63 bln.

Europe

Amidst the heightened economic turmoil, and the desire to show as united a front as possible in the face of Russian aggression, the EU-UK spat is set to intensify. The UK carried through with its threat to override parts of the treaty with the EU about not just Northern Ireland but also looking to diminish the role of the European Court of Justice. The EU has had several weeks to prepare a robust response. The EU's legal recourse was put on hold last September as a sign of good faith, and it is bound to resume these efforts. The eventual outcome could be fines. Assuming the bill passes, the UK government could override the 2019 agreement and impose its will on customs checks, tax, and arbitration. The euro is probing the upper end of its 12-month trading range against sterling near GBP0.8600. There was some intraday penetration last month, but euro has not closed above there since last September. It also is a (38.2%) retracement of the euro's decline from December 2020 (~GBP0.9230) to the March 2022 low (~GBP0.8200). The next retracement (50%) is around GBP0.8715, which correspond to the highs from April-May 2021. 

The UK jobs data failed to impress the market and the odds of a 50 bp hike later this week edged up slightly. The swaps market had 30 bp hike (a quarter-point move plus about 20% chance of a 50 bp move) at the start of last week. Yesterday, it edged up to 33 bp and now 35 bp. The employment report was mixed but still leaves the impression of overall strength. The number of people on company payrolls rose by 90k, better than expected, though the April gain was revised to 107k from 121k. Those claiming jobless benefits fell by 19.7k after falling by a revised 65.5k in April (initially reported as a 57k decline). Average earnings for the three months that ended in April slowed to 6.8% from 7.0%, while excluding bonuses, average weekly earnings rose at an unchanged pace of 4.2%. The ILO measure of unemployment unexpectedly ticked up (on an increase in the participation rate) to 3.8% from 3.7%. Vacancies reached a new record of 1.3 mln.

Fissures are appearing in the European bond market. As the yield rise quickens, the large sovereign debtors (periphery) are at a disadvantage. Premiums widen. The ECB net new bond buying will come to an end in a few weeks. The ECB has large discretion over the reinvestment of maturing proceeds, but the market is not persuaded this will be sufficient to prevent fragmentation. Indeed, monetary conditions are tightening faster in the periphery. Consider that in over the past week, the Italy's two-year yield has jumped 93 bp (Spain 72 bp and Portugal 61 bp) compared with 51 bp in Germany and 52 bp in France. Still, the German two-year yield rose above 1.0% yesterday for the first time since 2011 and is now slightly above 1.15%. The day before last week's ECB meeting (and two days before the US CPI), Italy's premium over Germany on 10-year bonds was hovering around 200 bp. It has surged to reach 240 bp yesterday the most in two years and is slightly above there now.

The euro has stabilized before the German ZEW investor survey. It ticked up from May, but the assessment of the current situation (-27.6 vs. -36.5) and the expectations component (-28.5 vs. -34.3) remain poor. The euro held $1.04 yesterday and dipped slightly below there in Asia before rebounding to $1.0485. Previous support around $1.05 now acts as resistance. The multi-year low set last month was $1.0350. We suspect that some of the pressure selling pressure on the euro stemmed from neutralizing the 3.3 bln euro of maturing options today struck at $1.0413 and $1.0425. Sterling fell to a two-year low yesterday just ahead of $1.21. It recovered to almost $1.2210 by late Asia but drifted lower in the European morning. Some bids emerged near $1.2145. The key today may be the dollar's overall direction rather than a UK-specific development.

America

There seems to be two ways to read yesterday's surge in US rates, and in particular the shift in expectations toward a 75 bp hike tomorrow. The first seems to be the most popular explanation. It is not coincidental, they say, that leading financial news sources came out with stories showing that despite what seems like a commitment to lift the target rate by 50 bp, there was ample wiggle room to allow for a 75 bp move. Fed officials may have reached out to media sources and perhaps without violating the quiet period ahead of tomorrow's meeting, reminded that central bank has the flexibility to ratchet up the size of the move. The second is that the market did it by itself, trying to anticipate the FOMC's reaction function after the stronger than expected CPI print and increase in inflation expectations (University of Michigan survey and the NY Fed's consumer survey). The Fed funds futures has a 75 bp hike practically fully discounted. In this narrative, the market has given the Federal Reserve a free option to hike by 75 bp.

If the Federal Reserve does not want to add to the market turmoil, the question is what is more destabilizing at this point a 50 bp or 75 bp move?  The market is saying a 75 bp move may be less disruptive. We suspect that the sharp rise in the volatility in the Treasury market, and other signs of dislocations, including the three-month bill auction that generated a nine-basis point tail, the largest since Lehman's failure in September 2008, draw the official attention it deserves. Today's PPI report is less important than last week's CPI. However, while the year-over-year rates may ease slightly, the acceleration of the month-over-month gains underscore the continued pressure.

Last Wednesday, the US dollar recorded a low near CAD1.2520. It was the lowest level since April 21. The greenback has soared and reached CAD1.2900 yesterday and has extended those gains to almost CAD1.2925. There may be potential toward CAD1.2945 today, but the market is stretched. However, the Canadian dollar may need two developments to stabilize. First, it continues to be highly sensitive to risk appetites (S&P 500 proxy) so a better tone in US equities may help. Second, Canada's two-year premium over the US had widened to almost 35 bp in the middle of last week. It fell to less than five basis points yesterday, the smallest in over a month. A break below CAD1.2850 would help stabilize the tone. Similarly, the greenback is extending its recent gains against the Mexican peso. Recall that the dollar has fallen to two-year lows against the peso in late May (~MXN19.4135), and yesterday poked above MXN20.50 for the first time since end of April. It briefly traded above MXN20.57 today. The next upside target is that late April high (~MXN20.6380) and the MXN20.68 area, which corresponds to the (61.8%) retracement of the greenback's slide from the March high (~MXN21.4675). Banxico meets next week and the risk of a 75 bp hike has increased.

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