Is a 0.3% Miss on Headline CPI Really Worth a 77 bp Rise in the December Fed Funds Yield?

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Marc Chandler
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Overview: Better than expected Chinese data and an unscheduled ECB meeting are the highlights ahead of the North American session that features the May US retail sales report and other high frequency data before the outcome of the FOMC meeting. Asia Pacific equities outside of Hong Kong and China fell. Europe’s Stoxx 600 is up almost 1% as it tries to snap a six-day slide. US futures are posting modest gains. Bond markets in Europe and the US are rallying. The ECB meeting has spurred a dramatic narrowing of the peripheral premium. The 10-year US yield is off 8 bp to about 3.4%. The dollar is weaker against all the major currencies. The Australian dollar leads with almost a 1% gain. Most emerging market currencies are also firmer. The Hong Kong Monetary Authority intervened selling about $1.2 bln to defend the HKD peg. Gold found support ahead of $1800 yesterday and is near $1825 in Europe. July WTI peaked yesterday near $123.70 and is offered below $117.50 now. US natgas has stabilized after falling 16.5% yesterday. Europe’s benchmark is up almost 2.6% to extend yesterday’s 15.5% surge. Better than expected Chinese industrial output figures failed to provide much support of iron ore prices, which fell around 2.8% to extend the losing streak to the fifth consecutive session. Copper is slightly higher for the first time in five sessions. July wheat is off about 0.5% after a 2% fall yesterday.

Asia Pacific

Today's data dump showed that the Chinese economy began recovering last month from the disruption caused by the zero-Covid policy. Industrial output rose 0.7% year-over-year rather than contract by 0.9% as economists (median forecast in Bloomberg' survey) expected. In April, it had fallen by 2.9%. Retail sales were off 6.7% year-over-year in May after dropping 11.1% in April. This was also better than expected. Surveyed unemployment eased to 5.9% from 6.1%. Economists had expected an unchanged report. Fixed asset investment and property investment disappointed. Fixed asset investment rose 6.2% this year through May compared to a year ago, slowing from the 6.8% rise in April. Property investment was off 4% in May after falling 2.7% in the first four months.

China also left its one-year medium-term lending facility at 2.85%, where it has stood since the 10 bp cut in January. Some observers looked for a small cut on ideas that consumer price pressure is low and producer prices have continued to ease, while the economy looks off course to reach 5.5% growth target. Still, the PBOC has been reluctant to use monetary policy much so far preferring instead to use regulatory power, fiscal incentives, guidance, and suasion. The PBOC also rolled over in full CNY200 bln (~$30 bln) in maturing loans.

Australia's 10-year bond yield soared 24.5 bp today to almost 4.2%. The new government made good on its campaign promise to hike the minimum wage. During the campaign, Prime Minister Albanese advocated matching the 5.1% increase in consumer prices in the first quarter. The President of the Fair Work Commission announced a 5.2% increase starting next month. The minimum wage will increase by A$40 to A$812.6 a week. The new hourly rate is A$21.38. The 5.2% rise is twice the annual wage price index of Q1 (2.4%). The decision came after a hawkish speech by RBA Governor Lowe, who warned that inflation could hit 7% this year. Lowe said it was "reasonable" to expect rates will rise to 2.5% from 0.85% now. The cash rate futures see it reaching that in three meetings (July, August, and September). The futures market has 56 bp hike next month (July 5), while the swaps market is closer to 75 bp.

The dollar edged up to a new multi-year high late yesterday to reach almost JPY135.50. The upticks were extended marginally to JPY135.60 in early Asia turnover before sellers emerged. The greenback was driven to nearly JPY134.50 where is stabilized. Yesterday's low was slightly below JPY133.90. The dollar has not taken out the previous day's lows since May 26. The Australian dollar is recovered from the $0.6850 area approached yesterday. Recall that the two-year low set in mid-May was near $0.6830. The session highs ae being recorded in the European morning near $0.6940. Yesterday's higher was around $0.6970. A move above $0.7000 would stabilize the technical tone. The greenback slipped to a three-day low against the Chinese yuan by CNY6.7115. It peaked yesterday closer to CNY6.7610. The dollar's reference rate was set at CNY6.7518. The median projection in Bloomberg's survey was CNY6.7524. In four of the past five sessions, the dollar's reference rate was below the survey median.

Europe

The ECB is holding an unscheduled meeting to ostensibly talk about market developments. The key market development was not the euro's dip below $1.04 yesterday, but the dramatic increase in rates, and more importantly the widening of the peripheral spreads over the Germany. The "fragmentation" dilutes the effectiveness of the ECB's monetary policy. While the ECB ostensibly has a single mandate, to achieve it the ECB recognizes it must contain the divergence of interest rates among its members. The Italian premium over Germany widened to a two-year high near 225 bp yesterday, but to be sure, it is not just Italy. Spain's premium rose to 136 bp yesterday, also its highest level since the chaos when the pandemic struck.

It is not clear what the ECB can do. We noted that as a compromise last year when some advocated a new mechanism to contain the "fragmentation." It was to give the ECB greater flexibility to reinvest maturing proceeds. We have also argued that a tool already exists (European Stabilization Mechanism) but it the support is tied to conditionality. Market talk suggest a more formal agreement on reinvestment of the maturing issues under the Pandemic Emergency Purchase Program can be forthcoming. However, if that is all it is, the markets will likely be disappointed and unwind the euro and bond market gains. ECB's Schnabel, who oversees the central bank's market operations says commitment to resist fragmentation has no limits. A disappointed market may be tempted test the resolve.

There are a few other developments to note. First, the EMU aggregate April industrial production figures were in line with expectations. The 0.4% rise follows an upward revision to the March series to show a 1.4% contraction rather than loss of 1.8%. Second, the eurozone reported a record trade deficit of 31.7 bln euros in April, more than twice what economists (median, Bloomberg survey) anticipated. Rising energy prices seemed like the major driver. Third, much to the chagrin of the UK government, the European Court of Human Rights blocked the first flight that was going to deport refugees to Rwanda.

News of the emergency ECB meeting helped lift the euro, which for the third session found bids near $1.04. The euro traded above $1.05 in the European morning, though was unable to take out the week's high set on Monday slightly shy of $1.0525. The (38.2%) retracement of the euro's decline since the US CPI figures is closer to $1.0540. There are options for almost 610 mln euro that expire today at $1.05. We suspect that if the high is not in place on the ECB news it is close, and we are concerned that the market's may be disappointed with the results. Sterling closed below $1.20 for the first time since March 2020. It is firmer today and did not take out yesterday's low (~$1.1935). It rose to almost $1.21 but this too looks like the extent of the move of nearly so. The Bank of England meets tomorrow, and swaps market has a little less than a 1-in-3 chance of a 50 bp move discounted. 

America

The market's reaction to a 0.3% miss on the headline CPI (vs. Bloomberg survey median forecast) and 0.1% on the core rate (which still eased by 0.2% to 6.0%) was violent, triggering dislocations throughout the credit market. The implied yield of the December Fed funds futures was around 2.75% before the CPI report. The implied yield has risen 77 bp in the past three sessions and settled yesterday at about 3.55%. The increase expectation for the overnight rate can account for the 45 bp increase in the 10-year yield. Doesn't this seem a bit much?  The core rate did ease for the second consecutive month, and reason the core is discussed is not simply because it excludes volatile components, or that it is widely recognized that monetary policy has little impact on food or energy prices, but because over time, headline inflation converges to core inflation, not the other way around.

Before entering the quiet period ahead of this week's FOMC meeting, a solid consensus appeared to emerge for a 50 bp hike in June and July, with the usual caveats the preserved ultimate flexibility. The Fed funds futures market has nearly fully discounted a 75 bp hike today and in July before another 50 bp move in September. The swaps market has the terminal Fed funds rate at 4.17% now, up nearly 70 bp since the CPI report. Monetary policy impacts come with the famous variable lags and leads. Should we really be convinced from one high frequency measure of inflation that it does not target would so dramatically change the course of monetary policy?  Arguably a 75 bp hike that the market has discounted risks injecting more volatility into the disrupted Treasury market may altering is reaction function.

Mr. Market is trying to deliver a fait accompli to the central bank, which there seems to be universal recognition that it is behind the inflation curve. It has hiked market rates sharply and the precipitous drop in equities points to the tightening of financial conditions, as if the Fed has already tightened. If the Fed were to hike by only 50 today, would the financial conditions ease. A 50 bp cut could almost seem dovish especially for a market that tends to see Powell as dovish even though between the rate hikes and the balance sheet, the Fed has launched the most aggressive tightening cycle in a generation. Many observers begin with an unspoken premise that the Fed has lost its anti-inflation credibility, but maybe this is a prejudice. The jump in rates is expecting what the Fed will do, and that is to stabilize prices even if it boosts the chances of a recession. Is this anti-inflation cred? The FOMC statement, the up-dated economic projections (the dot plot), and press conference offer many channels through which the Fed could underscore its commitment to its stable price mandate,

We say that that Fed will tighten policy until something breaks. The University of Michigan's preliminary June results showed a rise in inflations but also sentiment readings that have been associated with a recession in the past. With 30-year mortgage rates rising about 6%, it is reasonable to expect some slowing in the housing market. Before the FOMC meeting concludes, investors and policy makers will see the weekly mortgage market activity index, which has fallen for the past four week. The NAHB Housing Market Index, the Empire State manufacturing survey, and import/export prices may draw some interest, but the real focus is elsewhere. May retail sales will have been held back by disappointing auto sales, though a broad slowing is expected. The components which GDP models picked up from different time series, like auto sales, gasoline, food services, and building materials, can be excluded. The remaining "core" retail sales measure rose 1.1% in March and 1.0% in April. It is expected (median Bloomberg survey) seen at 0.3% last month. Remember retail sales is reported in nominal terms, which means that rising prices inflate the numbers.

Over the last five sessions, the US dollar jumped about a little more than 3.6% against the Canadian dollar to reached CAD1.2975 yesterday. It was the highest level in a month. Today is the first session in five that the greenback may not take out the previous day's high, but do not bet on it. The flattish consolidation is not inspiring,  and the Loonie is the poorest performing major currency through the European morning with a gain of less than 0.05%. The general risk environment is the most important near-term driver, so watch the S&P 500. The Canadian two-year premium, which fell from 30 bp last week to less than 3 bp yesterday has widened back to around 12 bp today. In the four sessions through yesterday, the greenback rose almost 6% against the Mexican peso to reach MXN20.69. It too is consolidating today in a narrow range mostly above MXN20.53. The central bank is seen hiking 75 bp next week, but there is a risk of a 100 bp move. Brazil's central bank is expected to hike the Selic rate 50 bp to 13.25% later today. The central bank is getting close to the peak, but the swaps market sees the risk of another 100 bp before it is over. The next meeting is August 3. Year-to-date, the Brazilian real has appreciated almost 9% against the US dollar, the best performing EM currency (excluding Russia). However, so far in June, the real has been the worst performer, falling about 7.5%. 

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