Recession vs. Inflation Battle Rages On

The recession vs. inflation battle is increasingly shifting towards the former as reflected in the recent paring back in US Federal Reserve tightening expectations and growing market pricing of rate cuts beginning as soon as early next year.  The weakness in the US July Services purchasing managers index (PMI) added more weight to this argument.  This week’s second quarter US Gross Domestic Product (GDP) data is likely to confirm two quarters of negative growth, which should mean technical recession though in the case of the US, recession is defined by the US National Bureau of Economic Research (NBER) as “a significant decline in economic activity that is spread across the economy and lasts more than a few months”.  Either way, the US economy is on a softer path.

This week is a big one for events and data. The Fed is widely expected to hike US policy rates by 75 basis points tomorrow. Expectations of a bigger 100bps move have been pared back. If the Fed does hike by 75bp it will likely result in interest rates reaching a neutral rate (the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive). At this meeting there will be a lot of focus on the Fed’s forward guidance but in reality the magnitude of hikes at the next FOMC meeting in September will be contingent on key inflation releases and other data, with two inflation reports (10 August and 13 September) to be published ahead of the next Fed meeting.

In Europe there was yet more disappointing economic news this week, with the German July IFO business sentiment survey falling sharply. The data gave a similar message to last week’s weak PMIs, provides yet more evidence that the German economy is falling into recession.   News that Russia has cut gas deliveries to Europe through Nord Stream 1 will only add to such concerns.  After surprising with a 50bp rate hike last week, the ECB arguably faces a bigger problem than the Fed.  At least in the US, the consumer is still quite resilient, with demand holding up well, while in contrast, demand is weak in Europe and the economy is sliding into recession at a time when inflation is around four times higher than target. 

Emerging markets have found some respite from the pull back in the US dollar over recent days, but it is questionable how far the dollar will sustain any pull back.  Increased worries about the US economy and a paring back of Fed tightening expectations could damage the dollar further, but let’s not forget that the Fed is still tightening more rapidly than many other major central banks, which ought to limit any US dollar weakness.  Even so, even if it’s a short-term phenomenon, emerging market currencies and bonds will find some relief from a softer dollar tone for now.  That said, many frontier economies such as in North Africa and South Asia are likely to struggle from higher food and energy prices for some months to come. If the dollar does resume its ascent it will only add to their pain. 

Central Banks Deliver Hawkish Surprises – What Will The Fed Do?

Following a series of more hawkish central bank action recently, 50 basis points (bp) hikes have become the new 25bp.  Several central banks surprised last week including a 100bp hike in Canada, 75bp hike in the Philippines and an inter-meeting tightening in Singapore. 

Meanwhile, while the upward surprise in US June CPI inflation (1.3% m/m) increased the chance of a 100bp hike from the Fed this month the University of Michigan sentiment survey revealed a decline in inflation expectations, with consumer sentiment languishing near all-time lows, dampening expectations of a larger move. 

While a 100bp hike at the 26/27 July FOMC meeting is quite possible after the Fed raised rates by 75bp last month, some Fed officials have dampened expectations of such a large move.  Officials such as Atlanta Fed President Bostic and Kansas City President George, have highlighted the risks that more aggressive rate increases would hurt the economy at a time when recessions risks have intensified. 

As we go into the Fed blackout period, with no Fed speakers ahead of the FOMC meeting and with the key June CPI print out of the way, there will be limited new news for markets to chew on.  Markets have fully priced in a little more than 75bp of Fed tightening this month, which seems reasonable, with a 75bp hike the most likely outcome.

This week has kicked off with another outsize increase in CPI inflation, this time in New Zealand where the Q2 CPI reading came in at 7.3% y/y (consensus. 7.1%, last 6.9%) reinforcing expectations of a 50bp hike by the RBNZ at its August meeting. 

There are several central bank decisions on tap in the euro area, Japan, China, Turkey, South Africa, Indonesia, and Russia.  The outcomes will differ.  The European Central Bank is primed to hike by a tepid 25bp, with focus on the likely announcement of an anti-fragmentation tool.  Not surprises are expected in Japan (Thu), China (Wed), Indonesia (Thu) and Russia (Fri), with policy likely on hold in all four cases. 

In contrast a 50bp rate hike from the SARB in South Africa (Thu) is likely while Russia is expected to cut policy rates by as much 100bp.   Aside from central bank decisions earnings releases gain momentum this week while Italian politics will remain in focus.  

The US dollar has kicked off this week on a weak footing after ending last week on a softer note. USD positioning remains heavily long though its notable that speculative positioning in the USD index (DXY) has slipped over recent weeks (according to the CFTC IMM data). 

Still stretched positioning and lower yields as markets pull back from aggressive Fed tightening expectations will likely cap the USD in the short term.   However, it’s hard to see the currency losing much ground, with EURUSD parity continuing to act as a magnet.  

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