UK Inflation Surprises to the Upside and Weighs on Sterling

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Marc Chandler
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Overview: The UK surprised with higher-than-expected consumer inflation and budget deficit, and the odds of a 50 bp hike tomorrow edged higher. Sterling has been sold on the news and is the weakest of the G10 currencies, off about 0.5%. The dollar is mixed with the euro, Swedish krona, Canadian dollar, and Swiss franc posting small gains. Emerging market currencies are lower, including the Chinese yuan, which is at new lows since last November. The Mexican peso, Hungarian forint, and Indonesian rupiah are firmer. Brazil's central bank meets late today, while most economists look for it to standpat, the risk for a rate cut.

US yields are edging higher ahead of Fed Chairman Powell's congressional testimony today, at which he is expected to reiterate the need to do more to ensure inflation returns to target and resilience of the labor market and economy indicate space to do so. European benchmark yields are mostly slightly firmer, while UK 10-year Gilt yields are about six basis points higher. Equity markets are heavy. Japan and Taiwan are exceptions, while Chinese and Hong Kong shares tumbled 1-2%. Europe's Stoxx 600 is off for the third session running and US equity futures are posting small losses. Gold is trading in about a $4 range on either side of $1935. A three-month low was recorded last week near $1925. August WTI is trading quietly around $71.

Asia Pacific

As the dollar climbed against the Japanese yen, three Japanese officials have commented on exchange rates in recent days, the cabinet secretary, the finance minister, and yesterday, the industry minister. Yet, and even though the yen is made new lows for the year, and is terribly under-valued, intervention is not imminent. The main driver is macro in the form of the policy divergence. "Higher for longer" in most of the G10 offers stark contrast with the Bank of Japan, which apparently is reluctant to even adopt a neutral bias, let alone hike the policy rate from minus 0.10%. Japan's economy grew at an annualized rate of 2.7% in Q1 and yesterday's upward revision to April's industrial output figures from -0.4% to 0.7% points to a better start to Q2 than had been feared. Yet, comments from BOJ Governor Ueda and board member Adachi seemed to play down the likelihood of a change in policy next month, which had been the subject of speculation as the central bank will update its economic projections. 

Japan's flash June PMI due Friday is likely to confirm the continued recovery. The May composite reading of 54.3 was the highest since October 2013. New orders hit a record high of 54.7. Friday also sees the release of the May national CPI figures. While the headline and core (excluding fresh food) rates may slip a little, the measures that excludes fresh food and energy, is seen rising to a new cyclical high of 4.2% (from 4.1%). It stood at 0.8% in May 2022. The incongruence of monetary policy with the economic expansion and underlying price pressures has pressured the yen lower. The verbal intervention seems more like an attempt to moderate the pace, like blowing air under a parachute, and indicating to its trading partners that is not seeking trade advantage.

That said, the dollar reversed lower yesterday after setting a new high for the year against the Japanese yen near JPY142.25. It was sold through Monday's low (~JPY141.45) but settled 1/100 of a yen above it, and unable to meet the technical definition of a key reversal. And the dollar bounced back today, resurfacing above JPY142.00, where there are expiring options for $870 mln. Above yesterday's high, the JPY142.50 is (61.8%) retracement of the dollar's decline from multiyear high set last year near JPY152.00. The Australian dollar fell to about $0.6755 yesterday and recovered to almost $0.6800 today where it was greeted with fresh sales. It is testing yesterday's low in the European morning and a break of it suggests a move to $0.6730, the (38.2%) retracement objective of this month's rally. Below there, the next target is $0.6680-$0.6700. The US dollar approached CNY7.10 at the end of last week and today is knocking on CNY7.20, a new high since last November. The policy divergence, and the broad strength of the greenback is the main driver. Meanwhile, whatever goodwill and optimism there may have been following US Secretary of State Blinken's visit to China seems to have been eroded by Beijing's objections to President Biden referring to Xi as a dictator and the US amending that Taiwan Relations Act and the so-called Six Assurances. The PBOC set the dollar's reference rate stronger than expected (CNY7.1795 vs. CNY7.1774) and this was seen as indicating lack of concern about the yuan's weakness.

Europe

The UK's May inflation was another shocker. The CPI rose 0.7% in May instead of 0.5% that had been expected, after jumping 1.2% in April. That meant that there was no improvement in the year-over-year rate at 8.7%. At an annualized rate through May, UK CPI has risen by 7.7%. Moreover, the core rate rose to a new cyclical high of 7.1% from May. Used car prices, air travel, and recreation prices helped lift the core rate. The fact that producer prices fell more than expected offered little consolation. Moreover, the UK reported a larger than expected budget deficit. The net result was an increase in the risk of a 50 bp hike tomorrow to near 30% and a higher trajectory. The year-end rate is now seen near 5.85% (4.50% currently), which is up from around 4.85% at the end of April and 5.35% at the end of May.

Sterling has found little comfort from the higher interest rate expectations and has been sold a little through yesterday's low ($1.2715). A break of $1.2700 targets $1.2650-75 but warns of a deeper retracement that could extend toward $1.2550. The euro is sidelined, confined to a narrow range (~$1.0905-$1.0935). Options for about 735 mln euros at $1.0950 expirer today. Monday and yesterday's high was about $1.0945. We suspect cross rate demand (against sterling and the yen) have helped prop up the euro. That said, hawkish comments from Fed's Powell in congressional testimony could see the euro test yesterday's lows near $1.0890 and then our initial target around $1.0860.

America

Many observers see the housing market as key element of the larger business cycle. It is among the most interest rate sensitive sectors. Higher interest rates lead to higher mortgage rates and a decline in activity. However, with existing homeowners reluctant to sell and give up their low-rate mortgages, supply of homes on the market is limited, and this has helped boost sentiment among home builders. And boom, May housing starts surged 21.7%, the most in seven years. Even with the downward revision to the April series (-2.9% from +2.2%), the absolute level of starts (SAAR) was 1.63 mln. That is the highest since April 2022 peak (~1.80 mln). Housing starts have recovered about 2/3 of the slowdown.

Half of the Federal Reserve governors and regional presidents speak in this holiday-shortened week. Fed Governor Barr and Fed presidents Williams and Bullard spoke yesterday. We will hear from Williams and Bullard later this week again. Fed Chair Powell is center stage today as he begins his semi-annual testimony before the House Financial Services Committee today and goes before the Senate Banking Committee tomorrow. Chicago Fed's Goolsbee also speaks today. He is a voting member of the FOMC this year, and although he is seen as among the more dovish members, he has yet to dissent from the rating hiking decisions this year. For now, it seems like officials are reading from the same sheet. The decision to pause last week has no implication for the July meeting. Still, the pricing of the Fed funds futures is consistent with around a 70% chance of a hike. Yet, the January 2024 Fed funds futures contract, which, without an FOMC meeting in January, offers a clean read of expectations for the year-end effective rate (weighted average, which is where the contract settles) is 5.21%. The current effective rate is 5.08%. This means the future market is pricing in about a 50% chance of one hike left alone two that the Fed has signaled. Looking a little downfield, next week's PCE deflator is likely to show that at an annualized pace headline inflation is running about half the pace seen in the first five months of last year, while the core measure is flat to maybe even slightly higher.

Canada is expected to report that April retail sales increased for the first time since January. In fact, the February and March declines (-0.2% and -1.4%, respectively), which offset January's 1.4% advance in full. There has been a significant backing up of Canadian two-year yield and it began before the central bank's quarter-point hike earlier this month. The recent low yield print was on May 11 near 3.60%. It reached a high to start the week slightly above 4.60%. The swaps market has an almost 60% chance of quarter-point hike at the July 12 meeting discounted. The Canadian dollar reached a new nine-month high on Monday near $0.7590 (~CAD1. 3175). The greenback tested the resistance we identified near CAD1 3265 (high was CAD1. 3270) yesterday and is consolidating today. A move outside the CAD1.3200-CAD1.3300 range would suggest the end of the consolidative phase. Mexico’s April retail sales reported yesterday jumped 1.5%, well above expectations (~0.2%) but was neutralized by the sharp downward revision to March. It was revised to -1.2% from flat. Net-net, retail sales were close to forecasts. Still barring a dramatic surprise from the CPI readings for the first half of June, released Thursday morning, Banxico is expected to standpat at its meeting later that day. Chile and Brazil are seen cutting rates ahead of Mexico, but the swaps market is pricing a cut from Banxico in Q4. The dollar settled above its five-day moving average against the Mexican peso for the first time since May 25. It saw follow-through gains toward almost MXN17.26 before easing again. A break of MXN17.30 could spur another leg higher. Lastly, Brazil's central bank meets late in the session. While a rate cut is coming, most economists see today's meeting as more groundwork. On Monday, the dollar recorded the low for the year slightly below BRL4.76.