Strong US Jobs Data And Hawkish Fed Speak Keeps Tightening Expectations Elevated

US bond yields rose sharply on Friday, particularly on the front end of the curve in the wake of the above consensus US July jobs report, which showed a strong 528,000 (consensus 250,000) increase in non-farm payrolls and the unemployment rate dropping to 3.5% (consensus 3.6%).  The three-month moving average of US jobs gains now total 437,000. However, the drop in the unemployment rate was due in part to a drop in the participation rate so it wasn’t all good news.  Wage growth was firm, with average hourly earnings up 5.2% y/y. Overall the data highlighted a still strong jobs market and markets are now pricing in a greater probability of 75 basis points hike by the Federal Reserve at its September meeting. 

The firm US jobs data accompanied hawkish Fed speak over the past week, with various Fed officials pushing back against more dovish rate expectations that had been built into markets over recent weeks. The Fed’s Evans, Kashkari and Daly are scheduled to speak this week and are likely to maintain the run of hawkish Fed comments, pushing back against residual expectation of an early peak in the Fed Funds rate. Despite weaker closes for equities on Friday, stocks still ended higher over the week, but may struggle given the renewed hawkish shift in rate expectations.  That said, with the bulk of second quarter earnings out of the way equities have held up well. 

The data and Fed speakers also give further reason to be cautious on extrapolating the recent pull back in the US dollar, with the currency bouncing at the end of the week and starting this week on a firm note.  The USD index has bounced off trend line support and has bounced off its 50-day moving average level, which has been a good support over recent months.  In the near term some consolidation in the USD is likely though this week’s US CPI inflation report is likely to provide more direction.  Conversely, while the euro appears to have found a short-term bottom, it’s hard to see a significant bounce in the currency. 

Data over the weekend revealed a stronger than expected increase in Chinese exports in July at 18% y/y (cons. 14.1%) and lower imports at 2.3% y/y (cons. 4.0%), resulting in a surge in the trade surplus to $101.26bn (cons. $89.04bn).  The weak imports data highlights ongoing pressure on domestic demand while exports will likely struggle to maintain firm momentum amid a likely slowing in external demand.  China’s July inflation data this will be in focus (Wed) this week while more reaction by China to last week’s visit by Speaker to Pelosi to Taiwan will also be expected. 

In the US, the key data will be the July CPI report (Wed); the consensus expects elevated readings of 8.7%/6.1% y/y for total/core prices.  Headline CPI will have moderated from June, but core CPI is likely to have ticked higher.  Long term inflation expectations as measured in the University of Michigan August confidence survey (Fri) will also be in focus.  On the policy rate front, a 25bp hike from the Bank of Thailand kicks of its tightening cycle (Wed) and a 75bp hike from Mexico’s central bank, Banxico.  However, unlike Thailand Banxico is likely nearing the end of its tightening cycle.   

Relief For Risk Assets, But How Long Will It Last?

Last week was one of considerable relief for risk assets; US equities recorded solid gains, with the S&P and Nasdaq up 6.2% and 8.2% respectively.  Conversely, oil (Brent) dropped by over 4% and the US dollar index dropped by around 1%.  Reflecting the improvement in sentiment, the VIX “fear gauge” has now dropped by around a third over the last couple of weeks to settle below 25.0.  The MOVE index of interest rates volatility has also fallen sharply.  All of this in a week when the Federal Reserve hiked policy rates by a quarter percent and promised more to come in a hawkish meeting. 

A lot of the bad news was clearly in the price including the pricing of several Fed rate hikes, but with the war in Ukraine ongoing, peace talks appearing to make little progress, stagflation fears intensifying and a renewed rise in COVID cases in many countries due to a new variant (BA.2), we’re still very far from an all clear signal for risk assets.  Separately, the US administration appears no closer to persuading China into supporting a stronger stance against Russia; no statement was issued after the call between Presidents Biden and Xi at the end of last week.

China’s neutral stance on the war in Ukraine still poses risks to its markets as indicated by the sharp outflows of foreign portfolio capital over recent weeks.  After pledges made by the authorities to provide much needed stability to China’s economy and markets, the coming weeks will be scrutinised for follow up action.  On this note, China’s Loan Prime Rates (LPR) outcome today was in focus.  There was a small chance that China’s Banks would lower their fixings but after the unchanged Medium Term Lending Facility (MLF) outcome last week, the prospects of a cut had lessened. Nonetheless despite no change in policy today, recent official pledges of support suggest its only a matter of time before there is a cut in the policy rate.

Over the rest of the week there will be several other central bank decisions in focus, mostly in emerging markets, including in Hungary (Tue), Philippines, Norway, South Africa and Mexico (all on Thu).  Most are expected to hike rates. A 25bp hike in Norway is likely, 50bp hike in Mexico, 25bp hike in South Africa and 150bp hike in Hungary.  There will also be several Federal Reserve speakers on tap this week including Chair Powell (Tue), as well as Williams, Bostic, Daly, Mester and Evans.  They are likely to provide more colour following last week’s Fed rate hike, with focus on comments on balance sheet reduction and the pace of further tightening ahead.  

USD, EUR and JPY Outlook This Week

The USD lost more ground last week extending its drop from the early October. Interestingly its latest drop has occurred despite an uptick in risk aversion suggesting other factors are at work. Mixed US data and earnings have not given the USD much direction with a downbeat Beige Book counterbalanced by a firmer Philly Fed manufacturing survey and housing starts.

The data have not been sufficiently weak to fuel expectations of more Fed quantitative easing but some Fed officials including Yellen, Tarullo, Evans and Rosengren in indicating that further QE could be considered. The USD has therefore been somewhat undermined but will take its cue from data releases and events in Europe this week.

This data slate will be mixed but on balance will not support more Fed QE. In particular, Q3 Real GDP is expected to come in sharply higher than in Q2, with a 2.5% annual rate expected to be revealed. Other indicators will be less positive, with October consumer confidence set to slip further and remain at a recessionary level, while September durable goods orders will decline by around 1%.

Despite an expected increase in new home sales in September the overall picture of the US housing market will remain very weak. Overall, the USD may find some respite from the GDP report but the data will be seen as backward looking, with the jury still out on the issue of more quantitative easing.

The EUR struggled to make any headway last week amid a barrage of rumors about the outcome of Sunday’s EU Summit. In the event the summit failed to deliver concrete details although there appeared to be some progress in key areas. Attention will now turn to Wednesday’s summit but once again the risk of disappointment is high. EUR/USD will only extend gains if markets are satisfied at the result but this is by no means guaranteed.

Data releases will not be supportive for the EUR this week, with a further deterioration in ‘flash’ eurozone purchasing managers indices (PMIs) and European Commission confidence surveys expected in October but hopes of a concrete resolution at Wednesday’s EU Summit will keep the EUR/USD supported early in the week although it will find strong resistance around 1.3915.

The sensitivity of the JPY to risk aversion has actually fallen over the last three months while the influence of bond yield differentials also appears to have slipped. The fact that USD/JPY continues to remain in a very tight range with little inclination to break in either direction despite gyrations in risk and yield differentials almost appears if the currency pair has been pegged.
Obviously this is not the case but a break out of the current range does not look imminent.

Speculative JPY positioning has dropped over recent weeks while equity and bond flows have overall been negative but this has not been reflected in JPY weakness resulting in increased frustration by Japanese officials. We continue to look for the JPY to weaken over coming months but much will depend on a widening in US / Japan yield differentials and easing risk appetite as both will regain their hold on the currency. In the meantime, the currency will continue to offer little to get excited about.

ECB to Hike, BoJ, BoE & RBA on Hold

The better than expected March US jobs report will likely help to shift the debate further towards the hawkish camp in the Fed. There is little this week to match the potency of payrolls in terms of market moving data this week. Instead attention will focus on a raft of Fed speakers over coming days as well as the minutes of the March 15 FOMC meeting.

This week’s Fed speakers include Lockhart, Evans, Bernanke, Kocherlakota, Plosser and Lacker. Of these only Lockhart and Lacker are non voters. Given the intense focus on recent Fed comments FX markets will be on the lookout for anything that hints a broader Fed support for a quicker hike to interest rates and/or reduction in the Fed’s balance sheet.

In any case the USD may struggle to make much headway ahead of an anticipated European Central Bank (ECB) rate hike of 25 basis point on Thursday. Much will depend on the press statement, however. If the ECB merely validates market expectations of around 75bps of policy rate hikes this year the EUR will struggle to rally.

It may also be possible that once the ECB meeting is out of the way the EUR may finally be susceptible to pressure related to ongoing peripheral tensions. Last week the outcome of the Irish bank stress tests, and political vacuum in Portugal ahead of elections set for June 5 were well absorbed by the EUR but it is questionable whether the dichotomy between widening peripheral bond spreads and the EUR can continue.

The Tankan survey in Japan released today unsurprisingly revealed a deterioration in sentiment. The survey will provide important clues for the Bank of Japan (BoJ) at its meeting on April 6 & 7th. Although a shift in Japan’s ultra easy monetary policy is unlikely whilst strong liquidity provision is set to continue, pressure to do more will likely grow. This will be accentuated by a likely downward revision in the economic outlook by the BoJ.

The JPY will not take much direction from this meeting. Nonetheless, its soft tone may continue helped by foreign securities outflows (particularly out of bonds), with USD/JPY eyeing the 16 December high around 84.51. Speculative positioning as reflected in the CFTC IMM data reveals a sharp deterioration in JPY sentiment as the currency evidence that finally the currency maybe regaining its mantle of funding currency.

It is still too early for the Bank of England to hike rates despite elevated inflation readings and MPC members are likely to wait for the May Quarterly Inflation Report before there is decisive shift in favour of raising policy rates. Even then, members will have to grapple with the fact that economic data remains relatively downbeat as reflected in the weaker than expected March manufacturing purchasing managers index (PMI) data.

Today’s PMI construction data will likely paint a similar picture. The fact that a rate hike is not expected by the market will mean GBP should not suffer in the event of a no change decision by the BoE this week but instead will find more direction from a host of data releases including industrial production. GBP has come under growing pressure against the EUR since mid February and a test of the 25 October high of 0.89415 is on the cards this week.

Finally, congratulations to the Indian cricket team who won a well deserved victory in the Cricket World Cup final over the weekend. The celebrations by Indians around the world will go on for a long while yet.

Eurozone peripheral tensions

The USD index remains under pressure but will likely continue to consolidate. The USD continues to be undermined by adverse interest rate differentials and is gaining little support from rising risk aversion. One factor that will help dictate USD direction over coming months is the prospects for further quantitative easing once QE2 ends.

Fed officials offered varied views on the subject. Dallas Fed President Fisher hinted he would support cutting short asset purchases before the end of June, whilst Atlanta Fed President Lockhart noted he was “very cautious” about further asset purchases. Meanwhile Chicago Fed President Evans noted that he believes the hurdle for altering the asset purchase plan is “pretty high”.

Although there is a lack of first tier data releases in the eurozone this week there is certainly plenty for markets to chew on in terms of peripheral country issues, which may just prevent the EUR from extending its gains. Eurozone peripheral debt spreads have undergone a renewed widening over recent weeks as debt fears have increased and worries that Portugal may follow Ireland and Greece in needing a bailout have risen.

Meanwhile news that Ireland’s incoming government will introduce legislation allowing the restructuring of some senior bank bonds, will add to tensions. Meanwhile, the downgrading of Greece’s government bond ratings to B1 from Ba1 dealt another blow sentiment following hot on the heels of Fitch’s downgrade of Spain’s outlook to negative although the EUR proved resilient to the news. EUR/USD continues to look as though it will consolidate around the 1.4000 level, but worsening sentiment towards the periphery may open up downside as the EUR’s resilience fades.

Upward revisions to eurozone growth and inflation forecasts and of course a hawkish shift in eurozone interest rate expectations may have justified the EUR move higher over recent weeks. However, there does not seem to be much that will provide the stimulus for further gains from current levels.

The market has already priced in an interest hike as early as next month’s European Central Bank (ECB) meeting and further tightening thereafter. The risk now appears asymmetric skewed to the downside especially if tensions between the eurozone core and peripheral countries deepen. How long the EUR can ignore such tensions?

It’s not only the eurozone periphery that should worry about ratings. Japan’s ratings agency R&I has warned that it may be forced to cut Japan’s sovereign ratings before April’s local elections due to current political problems. R&I’s concern revolve around the potential for political problems to delay fiscal reforms. As usual the JPY remains unmoved by political issues and is moving to the stronger side of its recent range against the background of elevated risk aversion.

Although the JPY has not been particularly sensitive to risk over recent months shorter-term correlations shows that its sensitivity has increased. Given that Middle-East tensions do not appear to be easing the JPY will remain well supported. Indeed, speculative positioning data reveals the highest JPY net long position since November 2010. As risk appetite improves JPY positioning will be pared back but this is unlikely to be imminent, with USD/JPY set to remain close to support around 81.10.

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