Does the US Inflation Report Matter or Has it Been Superseded by Deflationary Forces of a Financial Crisis?

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Marc Chandler
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Overview: The dramatic shift in expectations for Fed policy is a potent shock, with reverberations throughout the capital markets.  The business press was full of accounts putting the nearly 50 bp decline in the US two-year note in an historical perspective. Yesterday, it fell by 61 bp as the market continued to unwind Fed hikes and reprice the chances of a cut as early as Q2. While the poorly received bill auctions suggests not significant deposit flight, the KBW ETF (cap-weighted US bank index) fell 11.3% yesterday about what it has lost last Thursday and Friday. Adding insult to injury, it settled below where it had opened. The shift in US rate expectations after the jobs report in early February helped the dollar recoup some of what it had lost in the October-January period. The leg that it stood on, which coincided with a technical correction to a four-month decline appears over. The momentum indicators have turned lower for the dollar broadly, suggesting a return to the lows seen earlier this year.

The dollar has come back better bid today, but generally consolidating, helped by a recovery of the US two-year yield (~4.25%). Despite some high-profile calls to the contrary, we suspect the Fed will still hike rates by 25 bp next week to signal a separation of systemic support and the conduct of monetary policy, a similar distinction the Bank of England made last year. The equity rout continued in the Asia Pacific, where the MSCI regional index is now nearly flat for the year. However, Europe's Stoxx 600 has stabilized and is up fractionally in late morning turnover after yesterday's 2.4% slide. US index futures are up about 0.3%. Benchmark 10-year yields are firmer. The 10-year Treasury yield is up almost four basis points to 3.61%, while European yields are 8-10 bp higher, with UK Gilt yields up a little more. Gold is snapping a four-day advance that lifted it to almost $1915 yesterday. It is, so far, holding above $1900. May WTI remains near the lower end of this year's range and is trading a little above $73. 

Asia Pacific

Japan's extraordinary monetary policy was challenged by the rise in global rates and higher domestic inflation. Due to the government subsidies, the strengthening of the yen, and lower energy prices saw February inflation fall sharply. Now, the precipitous decline in global bond yields has removed the pressure on the upper band of the JGB (0.50% under the yield curve control). The ten-year generic yield settled above 0.50% consistently between February 10 through March 9. It fell to 0.41% before the weekend and is about 0.27% now, having fallen below 0.20% earlier today. the lowest since last August.

China's reports its February economic data tomorrow, and the market is expecting more evidence of a post-Covid recovery. The contrast with the US remains stark even if opposite of what it had been. Consider that early this month, China's 10-year yield was at almost 120 bp discount to US Treasuries. It fell to about 55 bp before stabilizing and is a little more than 70 bp now. The least for the year was around 48 bp. Tomorrow, China will set the one-year medium-term lending facility. It is expected to stand pat at 2.75% and the amount is likely to be reduced (~CNY350 bln from CNY500 bln).

The dollar fell through JPY134 yesterday to approach the JPY132 target (~JPY132.30). Firmer US yields are helping the greenback post corrective upticks today. It has reached the JPY134.35 area in early European turnover. The JPY134.50-JPY135.00 offers nearby resistance. The Australian dollar posted a five-day high settlement near $0.6665 after having earlier in the session briefly poked above $0.6700. However, it has spent little time above yesterday's close today and initial support is seen around $0.6620. A run above $0.6700 will likely find the next hurdle in the $0.6765-85 area. The greenback approached a four-week low yesterday near CNY6.8370 and recovered to about CNY6.8860, in line with the dollar's firmer tone overall. The PBOC set the dollar's reference rate tightly against expectations (CNY6.8949 vs. CNY6.8946). Note that one-month implied volatility for the offshore yuan (CNH) rose to nearly 7.8%, the highest since mid-December.

Europe

UK Chancellor of the Exchequer Hunt presents the spring budget tomorrow. Lower energy prices and better revenues gives some latitude, but no tax break is likely until closer to the elections (likely next year). The focus seems to be on two things. First, provide some incentives to draw some of the 6.6 mln adults who are recorded as economically "inactive", neither working nor looking for a job. It has risen by 500k over the past three years. This may include inducement to the nearly one million that retired early. It may include some incentive for daycare. The second is that while going forward with the corporate tax increase (to 25% from 19%) that Sunak pushed through in 2021, the government may seek to blunt it by providing a new effort to promote investment. The "super-deduction" that allows a significant tax break for investment expires at the end of this month. A tax hike and a loss of an important deduction would be too much for the Conservative Party to ask. 

The UK labor market is proving resilient. The ILO unemployment rate was steady at 3.7%, defying expectations of an increase. The claimant count fell by 11.2k after a revised 30.3k decline in January (originally a 12.9k decline). Employment grew a little faster than anticipated over the three months through January (65k vs. 53k), though a bit slower than in Q4 22 (74k). Average weekly earnings growth also moderated in January to 6.5% excluding bonuses from 6.7% in the previous three-month year-over-year period. Public sector pay rose 4.8% while private sector wages from by 7%.

The banking crisis has fueled a sharp drop in US and European interest rates. In the last three sessions before today, the US 2-year note fell by nearly 100 bp, while the German yield fell by about 65 bp, for example. The ECB meets Thursday and the market had been very sure of a 50 bp hike, but now see 25 bp and about a 50/50 chance of the other 25 being delivered. The market is a little bit more confident of a 25 bp hike in the US (~69%). The two-year interest rate differential, which is often a good guide, has fallen dramatically—from around 180 bp on March 8 to less than 135 bp yesterday. This is a big move and is back to levels seen in Q4 21. It is now near 147 bp.

The euro settled above $1.07 for the first time in a month. The (50%) retracement of the decline from the February 2 high (~$1.1035) is found near $1.0780. Today's pullback to around $1.0680 found new bids. A break of the $1.0650 would suggest a consolidative phase. On March 8, sterling approached $1.1800 and yesterday tested $1.2200, where the upper Bollinger Band is found. The mid-February high was closer to $1.2270 and stands in the way of the double top near $1.2450. It is in a tight range today in the upper end of yesterday's range finding initial support by $1.2140. Near-term risk seems to extend closer to $1.2100.

America

The market is concluding that the fragility of the financial system will prevent the Federal Reserve from continuing its aggressive monetary efforts to curb price pressures. February CPI today is expected to show a 0.4% increase at both the headline and core levels. If so, this could see the year-over-year rate ease to 6.0% for the headline (from 6.4%) and 5.5% for the core (from 5.6%). There is likely to be more progress this month. Last March, the headline rate rose by 1.0%. If it were replaced by 0.5%, the 12-month rate will fall to about 5.5%. The core rate continues to be stickier. It rose by 0.3% in March 2022, so it is possible that the 12-month rate increases. Of note, the Cleveland Fed's inflation tracker has February CPI rising by 0.54% and 0.45% for headline and core respectively, producing year-over-year rates of 6.21% and 5.54%. This month's CPI is said to be tracking 0.27% headline and 0.45% core, which would produce 12-month rates of 5.37% and 5.66%, respectively. 

Last week, the Canadian dollar was pressed to new lows for the year against the US dollar as the Bank of Canada declared a pause roughly at the same time the Fed and ECB seemed to signal higher for longer. That seemed to drive the exchange rate more than the risk appetite (S&P 500 proxy). The financial shock seen the US premium on two-year money fall to around 45 bp from a four-year high near 78 bp on March 8. It is back near 70 bp today. The swaps market had the year-end Bank of Canada policy a little below 4.80% on March 8 and now is slightly above 3.50%. Being tightly in the US economic orbit cuts both ways.

The US dollar set the high for the year before last week around CAD1.3860 and fell to about CAD1.3680 yesterday. True to today's larger pattern, it is consolidating within yesterday's range, and has been up to CAD1.3750. The CAD1.37770-CAD1.3800 looks to offer nearby resistance. The greenback remains bid against the Mexican peso. It has not spent much time below yesterday's MXN18.9130 settlement, spending most of today's session so far above MXN19.00. Yesterday's high, the best in a month, was a little shy of MXN19.18. Last month's high was near MXN19.29, which is the next obvious target, and a break of that could spur a move toward MXN19.50. However, we are more inclined to see some backing and filling and look for initial support around MXN18.75-80 to be tested.