Over to the BOE

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Marc Chandler
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Overview: Strong gains in US equities yesterday and easing fears following Pelosi’s visit to Taiwan helped lift most Asia Pacific equities, with Hong Kong leading the way with a 2% rally. Taiwan, Australia, and India did not participate in the regional rally. The Stoxx 600 is edging higher today. It was flat on the week through yesterday. US futures are a little firmer. The greenback is offered against the major currencies led the Antipodeans. The Japanese yen continues to pare its recent gains, encouraged by the recovery in US yields. Most emerging market currencies are also trading firmer. A few central European currencies have joined the Indian rupee to trade a bit lower. The 10-year JGB, which is capped at 0.25%, is below 0.18% today. The US benchmark is firm near 2.73%, while European yields are a little softer. Gold is nearing $1780 after it approached $1750 yesterday. September crude oil fell to almost $90 a barrel yesterday but has stabilized today around $91. US natgas soared by nearly 7.3% yesterday amid indications that a key LNG export platform will come back online in October to a greater extent than had been anticipated. US natgas is up another 1% today. On the other hand, Europe’s natgas benchmark is off 3.65% today, which if sustained, would be the biggest pullback in nearly a month. China’s woes are weighing on iron ore prices. They fell nearly 4.2% today, matching yesterday’s loss and extended the losing streak into the fifth consecutive session. Copper is softer and has fallen for the past three sessions. September wheat has returned to levels seen before Russia’s invasion of Ukraine. It is off about 0.6% today, threatening to extend its drop for the fifth session in a row. 

Asia Pacific

China's live-munition harassment campaign around Taiwan continues today and reports suggest some disruption of sea and air traffic. The Biden administration did not seem to embrace Pelosi's trip initially, cautioning that the military did not think it was the best time. Biden reportedly told Xi that Congress was an independent branch of the government. However, the dynamics of American domestic politics prevented backing down once the wheels were set in motion and Beijing objected. Moreover, Pelosi's visit came within hours of the approval of the semiconductor bill that offers money and credits to semiconductor companies to build capacity in the US, provided they do not boost advanced chip making in China. Now, the administration finds itself in a more difficult position. It is trying to convince Democrats not to support a bill that would recognize Taiwan "as a major non-NATO ally". The media is fond of saying that Beijing recognizes the independent democracy as part of its, but the truth is in deed, most of the world also recognizes one-China and Taiwan is not represented in international organizations represented by countries, such as the UN and IMF. The bipartisan bill would not only provide $4.5 bln of military assistance, but also support Taiwan's inclusion in such international organizations. The bill looks to be delayed until next month.

A larger than expected June trade balance caps a week of positive news from Australia. Building approvals slipped less than expected in June (0.7% vs. expectations for a 5% drop) and the May series was revised higher (11.2% vs. 9.9%). The preliminary services and composite PMI were revised higher to reduce the slippage. Yesterday, Australia reported slightly better than expected Q2 retail sales. Earlier today, Australia reported a record trade surplus of A$17.67 bln, which was well above expectations. Exports rose by 5%, while imports increased by 1%. Net exports likely lifted Q2 GDP by as much as one percent, according to economists. Exports of metals soared 27% in June and food (cereals and grains) rose by 21%. Australian tourists lifted services imports by A$2 bln. Natgas exports rose 1.3% to a new record. Gold exports jumped by more than 76%, but totaled A$3.5 bln. Iron ore exports, in contrast, rose 5.7% to A$12.6 bln. One pocket of weakness was a 13.1% drop in coal exports (to A$12.2 bln). The RBA delivers its monetary policy statement tomorrow and the cash rate futures market is pricing about a 30% chance of a 50 bp hike next month.

The US 10-year yield has jumped from 2.51% on Tuesday to almost 2.85% yesterday and is consolidating today in the 2.70%-2.74%. The dollar bounced from Tuesday's two-month low near JPY130.40 to JPY134.55 yesterday. It is consolidating in a one-yen range below yesterday's high today. The JPY135 area corresponds to the (50%) retracement of the dollar's pullback from JPY139.40, a 24-year peak in mid-July. The next retracement (61.8%) is closer to JPY136.00. The market may turn a little cautious ahead of tomorrow's US jobs data. The Australian dollar is extending yesterday's recovery after falling to about $0.6885 yesterday, an eight-day low. It is near $0.6975 in near midday in Europe. The $0.6985 area corresponds to the (61.8%) retracement of this week's losses from Monday's high a little shy of $0.7050. There are options for almost A$600 mln at $0.7000 that expire today. The greenback traded quietly against the Chinese yuan, confined to yesterday's range (~CNY6.7450-CNY6.7590). It has flirted with the 20-day moving average (~CNY6.7465) on an intraday basis but has not closed below it in almost a month. The PBOC set the dollar's reference rate tightly against expectations from Bloomberg's survey (CNY6.7636 vs. CNY6.7638).

Europe

It is the Bank of England's turn. The market has wavered about the prospects a 50 bp hike today. The swaps market had it completely priced in most recently July 18-19. It has also been fully discounted in the third week in June. It was around 75% yesterday and near 80% now. Subjectively, we suspect the odds of more forceful action is higher. While the market is focused on the size of the hike, the BOE's tightening has another dimension. BOE Governor Bailey is also likely to sketch its balance sheet strategy.

Unlike the Federal Reserve, for example, the BOE is likely to shrink its balance sheet through outright sales, not just more passively managing the managing the pace of roll-offs. This is one way in which QE can become normalized. Use it in an emergency, and when the emergency passes, end it quickly and reduce the balance sheet. However, Bailey has argued that the central bank needs to reduce its balance sheet, so it is prepared for the next emergency to go "big and fast."  This would seem to suggest some fixed capacity of the central bank's balance sheet. It begs the question the origin of the limit. Consider, that the Bank of Japan's balance sheet is around 133% of GDP. The BOE's peaked at 42% of GDP last year, and as of the end of last month was a little below 39%. There are some operational challenges. The BOE set its restrictions. It wants to cap its exposure to any one instrument at 70% of outstanding, and it appears to be bumping up against some in the 3-7-year tenor. These may be good candidates to actively reductions. The pace of the BOE's balance sheet reduction will be a factor in the market's response today but assessing the degree to which the shrinkage is represents the equivalence of rate hikes remains highly debatable. Consider that the BOJ's balance sheet fallen for the past three months, by around 1.8% (~JPY13.2 trillion) and no one has said that the BOJ has tightened policy.

The euro reversed lower on Tuesday and saw follow-through selling yesterday (to about $1.0125), to a six-day low, which correspond to the (50%) retracement of its rally from the mid-July 20-year low near $0.9950. The (61.8%) retracement is around $1.0080. The euro is firmer today but holding below $1.02. On the other hand, it remained above $1.0150, where 2.15 bln euros in options expire today. The intraday momentum indicators are over-extended and consolidation ahead of tomorrow's US employment data would not be surprising. Sterling is trading in about a quarter-of-a-cent range on either side of $1.2150, the opening level, ahead of the outcome of the BOE meeting. While sterling may trade higher on the BOE announcement, barring a significant surprise, we are inclined to fade it as it approaches yesterday's highs a little above $1.22. Note that later today, there is a debate between Tory leader contenders Truss and Sunak. The former continues to lead in the polls. Lastly, in addition to the BOE move, the Czech central bank is expected to lift its repo rate 25 bp to 7.25%. CPI in June stood at 17.2%.

America

Some of the Fed's critics complain about the cacophony of voices from the central bank. Yet, they have all been singing from the same song this week. They indicate that the Fed's fight against inflation is not over. Everyone may not agree with St. Louis Fed President Bullard who want to see the Fed funds target 3.75%-4.0% by year-end but is not doubt about the trajectory of Fed policy. The June dots (Summary of Economic Projections) showed that one official (Bullard?) had the year-end rate at 3.75%, and another four had its 3.625%. A vocal minority, for sure, while the median was at 3.375%, which was what eight of the 18 officials said. How has the market responded to what appears to be forward guidance?  The 2-year yield is up 21 bp in the past two sessions, and at 3.08%, is at its highest level in two-weeks. The implied yield of December has risen nine basis points. The market has also pared the extent of easing next year. The implied yield of the December 2023 Fed funds futures is 29 bp below the implied yield of the December 2022 contract. At the end last week, it was 50 bp.

Even if Fed officials were still in its quiet period before the FOMC meeting, a good case can be made that some adjustment would have taken place anyways because of the data. The PMI data was more or less known from the flash iteration. Aside for the JOLTS drop in job openings, the other high-frequency US data have been non-recessionary. Auto sales rose in July (2.7% month-over-month), and it was the first back-to-back increase since March and April 2021. The ISM manufacturing index was in line with the PMI (52.8 vs. 52.2). The ISM services, on the other hand, rose to 56.7 from 55.3 as opposed to the PMI services that fell to 47.3 from 52.7 (and 47.0 preliminary estimate). June durable goods orders had already been reported and the final version was tweaked to 2.0% from 1.9%. However, factory orders surprised on the upside, rising 2.0% instead of the 1.2% median forecast in Bloomberg's survey and the May's gain was revised to 1.8% from 1.6%. A detail that may not be fully appreciated is the strength of defense orders. It is not only the US military, but US factories will also benefit from the increased military spending in Europe (including Germany), Middle East, and Asia.

Canada reports June building permits and trade figures today but are not typically market movers. Tomorrow, Canada, like the US, reports July jobs data. Yesterday's gains in the Canadian dollar underscore our emphasis on the risk environment (the correlation with the S&P 500). September WTI fell 4% yesterday and tumbled nearly 5% on Monday. The Canadian dollar trades more as a risk asset then a petro-currency. Initial US dollar support is seen around CAD1.2830, with the nearby cap in the CAD1.2860 area. Yesterday, the greenback gave back most of Tuesday's 2.2% surge against the Mexican peso and is trading slightly heavier today. It is testing the 200-day moving average around MXN20.43. Below there, support is near MXN20.35. As widely expected, Brazil's central bank hiked the Selic rate by 50 bp to 13.75%. It kept the door open to another, albeit smaller rate hike, but it is clear, it is approaching what it suspects with be the terminal rate. The BRL5.32 area approached yesterday is an important technical area, and a move above it would target the BRL5.37 area. Support for the greenback is seen between BRL5.22 and BRL5.25.