Market Prices in More Aggressive Fed AND is more Confident of Rate Cuts by the End 2023

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Marc Chandler
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Overview: The higher-than-expected US CPI and the strong expectation of a 100 bp hike by the Fed in two weeks is propelling the dollar higher. It jumped to almost JPY139.40 and the euro is off more than cent from yesterday's high (though holding above parity). Even where there has been favorable economic news, like the strong jobs report in Australia, is failed to dent the greenback. Most of the large bourses in the Asia Pacific regions advanced. Hong Kong is a notable exception, and the Singapore and Philippines' stocks fell after the surprise tightening moves. Europe's Stoxx 600 is extending yesterday's 1% slide and is off around 0.8% in late morning turnover. The S&P and NASDAQ futures are trading lower. They have fallen in the first three sessions this week. The US 10-year yield is a few basis points higher around 2.96%. European benchmark yields are 8-18 bp higher, with Italian bonds getting hit political concerns. But the peripheral premium more generally is widening. Gold is returning to its lows after being turned back from around $1750 yesterday. August WTI is traded at its lowest level in three months near $93.40. Higher gasoline prices in the US have seen demand slump to around 8 mln barrels a day last week. In seasonally adjusted terms, it is the lowest since the mid-1990s. After surging 8.5% yesterday, US natgas is off around 1.2% today. Europe’s benchmark is off 2.5% today after rallying 10% in the past two sessions. Iron ore prices collapsed 8% today after rising 3.6% yesterday. September copper is giving back yesterday1% gain plus some. It fell more than 6.5% Monday-Tuesday. Lastly, September wheat is trying to snap a three-day decline. It is near five-month lows.

Asia Pacific

Australia's much stronger than expected employment report and news that China is considering lifting the almost two-year ban on its coal failed to lift the Australian dollar. After edging higher in the past two sessions, the Aussie is trading a little lower, though in yesterday's range. Australia created 88.4k jobs last month, almost three-times more than the median projection in Bloomberg's survey, and of them, nearly 53k were full-time posts. The participation rate rose to 66.8%, a new record high, while the unemployment rate tumbled to 3.5% from 3.9%. 

The city of Tokyo has lifted its Covid alert to the highest level as cases surge. According to reports, Tokyo has around 3.5k infections on July 1. Yesterday, it reached around 17k. Separately, foreign investors, who sold a record amount of Japanese government bonds, returned in a big way last week. Ministry of Finance figures show foreign investors bought JPY2.07 trillion (~$15 bln) last week, the second highest since the time series began in 2005. And that shocking 7.2% contraction in May industrial output (month-over-month) was revised to a 7.5% drop. Capacity use fell a stunning 9.2%. The weakness in household spending and this dramatic weakness warns that Japan's recovery from the contraction in Q1 stalled.

There were two surprise central bank moves in Asia today. First, the Monetary Authority of Singapore signaled tighter monetary policy by allowing the Singapore dollar to appreciate. The exchange rate is the main channel of monetary policy. Although the economy appeared to have stalled in Q2, inflation is rising, and MAS lifted its inflation forecast from 4.5%-5.5% to 5%-6%. Second, at an unscheduled meeting, the Philippines central bank announced a 75 bp hike of the key borrowing rate to 3.25%. After raising rates last month, the central bank was not due to meet until August 18. The US dollar slipped slightly against the peso, losing about 0.2% on the day.

The US dollar has jumped to around JPY139.40. There were options for nearly $1.5 bln at JPY139 that expired today and may have spurred more dollar buying as the greenback rose through the figure. The JPY140 level is the next target, however, the frenzied buying appears to have dried up for the time being. Below JPY139, support is seen in the eJPY138.60 area. US Yellen and Japan's Suzuki's statement earlier this week downplayed the likelihood of material intervention. The Australian dollar is languishing in its trough. Yesterday's attempt to resurface above $0.6800 was greeted with fresh selling. It is holding above the week's low set on Tuesday near $0.6710. The Chinese yuan slipped to its lowest level in a month as the greenback's strength proved too much. The US dollar rose to almost CNY6.75. which it has not seen since June 14 when it briefly traded above CNY6.76. The high for the year was in mid-May closer to CNY6.8125. The PBOC fixed the dollar tightly near expectations (CNY6.7265 vs. CNY6.7267. The PBOC indicated that there was plenty of liquidity and the overnight rate fell to an 18-month low.

Europe

The Tory Party is in the middle of picking Johnson's replacement. After yesterday's vote, eight candidates remain. Sunak got the most votes with 88, followed by Mordaunt with 67 and Truss with 50 to lead the field. Another vote will eliminate someone else today. There is scrambled to draw the supporters of the candidates that were eliminated or that dropped out. After the party votes get it down to two candidates by the July 21 summer recess, some 175k rank and file members will vote for and a new leader of the part and Prime Minister will be announced on September 5. A YouGov poll shows that among Tory members, Sunak would lose in a face-off against either Mordaunt or Truss.

While concerns about Italy's ability to cope with higher rates and the heatwave in the north, it is old-fashioned politics that is threatening it today. Former prime minister Conte, complaining that Five-Star Movement is not being listened to in the coalition government, threaten to boycott confidence vote (over an aid bill). The current prime minister Draghi has threatened to resign if Conte makes good on his threat. The political tension as Italian stocks and bonds underperform. 

Deputy US Treasury Secretary Adeyemo suggested that the design of the cap on Russian oil prices will be so attractive that there is "a natural incentive for countries to join this coalition."   Rather than ban insurers from covering any tankers that carry Russian oil, the US has been championing a cap slightly above Russia's production costs. Banning the insurers but not capping the price of Russian oil would likely lead to a surge in oil prices. The idea is that, if for example, India and China continue to buy Russian oil, they would likely demand lower prices too if the proposal were implemented. The use of secondary sanctions on countries that do not adhere to the cap is not envisioned now, Adeyemo said. Secondary sanctions are particularly odious to those who are subject to them as it often looks like extraterritoriality--the applying of US laws outside of the US.

The euro remains stuck near parity. After dipping slightly and briefly below parity yesterday, the euro bounced a little above $1.0120. However, the upticks provided a new selling opportunity, and it returned to a low today near $1.0005. While the euro is pinned near its lows, so is sterling. This week's two-year lows were set Tuesday, slightly above $1.1805. Yesterday, it recorded a high near $1.1965. Today, it has been capped below $1.19 So far today, it is holding above $1.1820, where options for almost GBP620 mln have been struck that expire today.

America

For the fourth consecutive month, US headline inflation surprised on the upside. Although the 9.1% rise in the headline was less than Tuesday's rumor of a double-digit print, it was the third month in the past four that the monthly increase was 1.0% of more. The market concluded two things, though most observers focused on one or the other. First, at the close yesterday, the Fed funds futures moved priced in a 60% chance of 100 bp hike later this month instead of 75 bp. Second, the market concluded that the more aggressive the Fed is in the short-term, the more likely it will "break something" and have to reverse itself. The implied yield of the December 2023 Fed funds futures contract settled 65 bp below the December 2022 contract. That is full confidence of 50 bp cuts and a 60% chance 75 bp. Today's PPI pales in comparison with the yesterday's CPI. And the modest increase in weekly jobless claims in recent weeks, while continuing claims remain near its trough, draws little attention, especially in light of last week's sharper than expected jump in nonfarm payrolls.

The US budget balance for June was reported yesterday. Fiscal policy is not getting the attention we think it should. Fiscal policy is tightening aggressively. Consider that in the first six months of the year, the US recorded a shortfall of about $137.5 bln. In the first six months of 2021, the deficit was nearly $1.67 trillion. The median forecast in Bloomberg's latest survey sees the US budget deficit falling from 10.8% of GDP last year to 4.5% this year. This appears to be the largest decline in percentage terms for more than half a century.

The Bank of Canada became the first high-income country to hike 100 bp. The target rate now stands at 2.50%. Governor Macklem explained that the hikes were being front-loaded to boost the chances of a soft-land, which is becoming more difficult. The Bank of Canada cut it GDP forecast to 3.5% this year from 4.2% and next year to 1.8% from 3.2%. He said the forceful action was needed to avoid a wage-price spiral. Macklem seemed to imply the rate hike did not mean a higher terminal rate. The market had been leaning to peak around 3.50% and now closer to 3.75%. The swaps market is pricing in about an 88% chance of a 75% hike at the next meeting on September 7. We are not persuaded by claims that the Bank of Canada move put pressure on the Fed to hike 100 bp. Given the Fed's reaction function to the June CPI report and the initial conditions, i.e., that the market had largely priced in a 75 bp hike, one does not need to even know what the BoC did to arrive at what the Fed is more likely to do.

The US dollar is trading at new highs for the week against the Canadian dollar near CAD1.3075. The high for the year was set on July 5 around CAD1.3085, which is where the upper Bollinger Band is found. A convincing break of CAD1.3100 were strengthen the US dollar's medium-term technical outlook, perhaps targeting the CAD1.33-CAD1.34 area. The greenback approached MXN21.00 yesterday for the first time in four months yesterday. It eased to settle near MXN20.73, but it has come back higher today and traded to almost MXN20.89. The high for the year set in early March around MXN21.4675. The upper Bollinger Band is slightly below MXN20.9450. 

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