Fed Day: Skip = Hawkish Pause, but Market Says Finito

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Marc Chandler
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Overview: The year-end effective Fed funds rate implied in the futures market is about 5.11%. The rate has been averaging 5.08% since the Fed hiked rates last month The Fed may go to pains to explain that the steady that to be announced later today is just a pause to get a better read on the economy, the market favors this to be the end of the tightening cycle. The dollar is trading softer against nearly all the G10 currencies. Emerging market currencies are more mixed, but JP Morgan Emerging Market Currency Index has steadied after slipping lower in the past two sessions. Gold is recovering after yesterday's outside down day and settlement below $1950. 

Outside of China, Hong Kong, and South Korea, most large Asia Pacific markets advanced, led by more than a 1% gain in Tokyo. Europe's Stoxx 600 is advancing for the third consecutive session, which if sustained will be the longest rally in two months. US index futures are trading with a firmer bias. After jumping nearly eight basis points yesterday, the US 10-year yield is a little softer today to about 3.80%. The US two-year yield rose by nearly nine basis points yesterday and is also a touch softer today near 4.65%. European 10-year benchmark yields are slightly firmer today, but UK Gilts which have been sold aggressively in recent days, have steadied with the yield near 4.40%. July WTI has edged back above $70 a barrel, helped by new quotas in China. This blunted the concerns about demand, which had helped press the contract to $66.80 on Monday. The International Energy Agency sees a sharp slowing in world demand growth next year, with falling inventories. In its first detailed look at next year, it sees a tight market, especially in H2 24.

Asia Pacific

The PBOC will set the one-year medium-term lending facility rate first thing tomorrow. It got large banks to cut their deposit rates and it cut the 7-day repo rate yesterday by 10 bp. If it does not deliver a small cut in the MLF rate (now 2.75%) tomorrow, it will disappoint and confuse the market. In turn, a cut in the MLF will likely signal that the banks will cut the loan prime rates next week. China's May data will also be reported tomorrow. The year-over-year, year-to-date measures are seen improving sequentially, though not property investment. The divergence of US and Chinese yields continued. The US premium over China on 10-year yields widened to almost 120 bp yesterday, the most since last November (~150 bp), which itself was the most since 2007 (~185 bp).

There has been speculation that Japan's Prime Minister Kishida would call for snap elections by dissolving the lower chamber of the Diet. The window of opportunity appears to be narrowing. First, the latest NHK poll some slippage in support for the prime minister. Second, the current legislative session ends on June 21, but it is seen being extended by ten days to finalize the passage of two bills (tighter immigration rules and increasing the defense budget). An opposition party (Constitutional Democratic Party) has threatened to trigger a confidence vote in protest of the government's plans to secure funds for the defense build-up. Kishida could use that to call for elections. However, there is another rub. Technically, the PM can dissolve the lower house, but it is the emperor that calls for the election, and Emperor Naruhito is scheduled to leave for a week-long trip to Indonesia on June 23.

The dollar posted an outside up day against the yen yesterday, trading on both sides of Monday's range and closing above Monday's high. It reached JPY140.30 yesterday and was capped there today, but it also has not below JPY139.85. There are options for about $770 mln at JPY139.50 that expire today, but ahead of the FOMC outcome, it seems too far away. Look for the exchange rate to track US rates in response to the Fed's decision. The Australian dollar is trading inside yesterday's broad range (~$0.6740-$0.6805) in quiet turnover. It has not settled above $0.6800 since late February. During its recovery this month, the Aussie has been climbing the five-day moving average and has not settled below it once this month. It is found near $0.6750 today. Today is only the third session this month that the Chinese yuan has not fallen. Still, the greenback edged to a new high for the year, drawing closer to CNY7.17 initially before pulling back. The PBOC set the dollar's reference rate at CNY7.1566 today, tight against the median projection in Bloomberg's survey of CNY7.1565.

Europe

Industrial output in the eurozone rose by 1.0% in April. Yet, all the national figures of the large members but France disappointed. German output rose half of the 0.6% expected after a revised 2.1% drop in March (from -3.4% initially). Italy's industrial production fell by 1.9%. The median forecast in Bloomberg's survey was for a 0.2% gain after 0.6% decline in March, the fourth consecutive decline. Spain's was expected to decline by 0.5% but slumped 1.8% (and March was revised to 1.3% from 1.5%). The Dutch manufacturing output have imploded. April's 3% decline follows a 1.8% fall in March. It rose by 0.1% in February after January's 3% drop. The ECB meets tomorrow and is widely expected to hike rates, extend its balance sheet unwinding efforts, and tweak its economic forecast (to likely show less growth and more inflation).

Following yesterday's stronger than expected jobs data, the UK reported the economy expanded by 0.2%. in April. Like in the eurozone, weakness is still evident in the industrial sector, where output fell by 0.3% (-0.1% expected). Construction output was poor, falling by 0.6%, the first decline in three months. Economists had expected a flat report. Services recovered, growing 0.3% after the 0.5% decline in March. The trade deficit narrowed more than expected. The Bank of England meets on June 22 and there is only one important high-frequency data point before it, the May CPI. It might not matter much because nothing will change the impression that price pressures are far too high. UK's CPI has risen at an annualized 10% in the first four months of the year.

The euro reached nearly $1.0825 yesterday, its best level since May 22. On the pullback in the Asia Pacific session the euro tested $1.0775 area before resurfacing above $1.08 in the European morning. Still, intrasession momentum indicators are stretched, and a consolidative North American session is likely until closer to the FOMC announcement. On the upside, the next important area is $1.0850, which is where nearly 2.5 bln of options expire Friday and the $1.0865 area that corresponds to the (50%) retracement of the decline from the May 4 high near $1.1100. On the downside, a break of $1.0740-50 area would disappoint the bulls. Sterling settled above $1.2600 yesterday, after recovering from Monday's dip below $1.2490. Follow-through buying lifted it to near $1.2650 in the European morning today. Recall that the high since last June was set on May 10 near $1.2680. There are options for GBP400 mln at $1.2700 that expire today. Given that the intraday momentum indicators are stretched, it may be too far for sterling ahead of the FOMC meeting. Initial support is seen in the $1.2600-20 area.

America

The FOMC meeting is The Focus. Some officials and market participants have introduced the word "skip" into the mix. It is not clear how that is really different than a hawkish hold. Perhaps, the new jargon is to suggest that the bar to a July move is low, but that is implied by the more familiar "hawkish hold."  It might even be surprising to see that new language used in the Fed's statement or by Chair Powell. We have identified three channels through which the Fed will express its tightening bias while standing pat. First, Powell will say so. He will likely explain that the decision not to hike rates at this meeting does not prejudge future meetings and that the Fed will react to incoming data to ensure that it remains on course to reach its inflation target. Second, the Summary of Economic projections is a communication tool. Here, the median forecast for growth will most likely be revised up from 0.4% in March. The median unemployment forecast was 4.5% in March, and this is too high and will likely be lowered. The median forecast for the year-end Fed funds may edge up from 5.1%. Recall that in the March iteration of forecasts, seven officials were above the median and one was below. At the same time, the Fed has signaled its willingness to cut rates before inflation is below 2%. The median forecast for the PCE deflator was that it would be at 2.5%), while the median year-end Fed funds forecast was at 4.3%, implying an easing cycle under way. Third, a dissent in favor of a hike by a regional president is possible. The Minneapolis Fed President Kashkari seems the most likely. The Dallas Fed President Logan also pushed against a pause, but she is among the newest at the Fed and may be reluctant to dissent so early in her tenure, (though it did not stop Kashkari from dissenting against a hike in March 2017, his first meeting).

The net effect of the May CPI report, where the headline slowed a touch more than expected and the core rate was slightly firmer than projected, was to further reduce the perceived likelihood of a hike today. The implied odds in the futures market slipped to about 10% from around 25%. Moreover, the odds of a July hike were downgraded to about 70% from almost 87% at the close on Monday. As we have noted, given the base effect (headline CPI rose 1.2% in June 2022), the US CPI could be in the low 3%-area when the Fed meets next at the end of July. This coupled with any signs that the US economy is slowing could make it more difficult for the Fed to resume tightening. The year-end average effective Fed funds rate is seen near 5.11%. The average effective rate has been steady at 5.08% since last month's hike. Going into today's decision, the Fed funds futures market is saying the Fed is done.

The US dollar broke below CAD1.34 last week, and after some consolidation, took out CAD1.33 yesterday, for the first time since mid-February. Although it did not close below that support, follow-through action today pushed the greenback to CAD1.3285. The low for the year was set in early February near CAD1.3260. A convincing break targets the CAD1.3200 area, the low from last November, which is the last significant support ahead of the CAD1.3000-50 area. The US dollar continues to grind lower against the Mexican peso. It broke MXN17.20 yesterday and briefly slipped through MXN17.18 today. We continue to see little that will prevent a test on the MXN17.00 area.