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. 

Market Cross-Currents

There are many cross currents afflicting markets at present.  Equity valuations look high but US earnings have been strong so far, with close to 90% of S&P 500 earnings coming in above expectations. This has helped to buoy equity markets despite concerns over the spreading of the Delta COVID variant and its negative impact on recovery.  Yet the market doesn’t appear entirely convinced on the recovery trade, with small caps continuing to lag mega caps. 

The USD index (DXY) remained supported at the end of last week even as US yields remain capped, but the USD does appear to be losing momentum. Positioning has now turned long according to the CFTC IMM data indicating that the short covering rally is largely exhausted; aggregate net USD positioning vs. major currencies (EUR, JPY, GBP, AUD, NZD, CAD & CHF as a percent of open interest) turned positive for the first time in over a year. 

Inflation fears have not dissipated especially after recent above consensus consumer price index (CPI) readings, for example in the US and UK.  Reflecting such uncertainty, interest rate market volatility remains high as seen in the ICE BofA MOVE index while inflation gauges such as 5y5y swaps have pushed higher in July.  There was some better news on the inflationary front at the end of last week, with the Markit US July purchasing managers indices (PMIs) revealing an easing in both input and selling prices for a second straight month, albeit remaining at an elevated level. 

This week we will get more information on inflation trends, with the June Personal Consumption Expenditures (PCE) report in the US (Fri), Eurozone July CPI (Fri), Australia Q2 CPI (Wed) and Canada June CPI (Wed), on tap this week.  We will also get to see whether the Fed is more concerned about inflation risks at the Federal Open Markets Committee (FOMC) meeting (Wed).  The Fed is likely to continue to downplay the surge in inflation, arguing that it is transitory, while the standard of “substantial further progress” remains a “ways off”.   Nonetheless, it may not be long before the Fed is more explicit in announcing that is formally moving towards tapering. 

An emerging markets central bank policy decision in focus this week is the National Bank of Hungary (NBH) where a 15bp hike in the base rate is expected.  Central banks in emerging markets are taking differing stances, with for example Russia hiking interest rates by 100 basis points at the end of the week while China left its Loan Prime Rate unchanged.  The July German IFO business climate survey later today will be in focus too (consensus 102.5).  Overall, amid thinner summer trading conditions market activity is likely to be light this week.

India Risks, Highlights For The Week Ahead

It was a strong end to last week for US markets, with S&P 500 up over 1%, helped by stronger than expected new home sales and April US Markit purchasing managers indices (PMI) data. As risk assets rallied the US dollar and US Treasuries sold off.  There are plenty of event risks this week. Also, there will be deluge of US earnings releases this week including most tech heavyweights while markets will likely remain nervous over President Biden’s tax plans.  Geopolitical risks will also remain on the forefront. 

Even as the progress on the vaccination front continues the renewed increases in virus cases in many countries, particularly in India, where the situation has deteriorated markedly, threatens to delay recovery. The acceleration in virus cases has been dramatic, with Prime Minister Modi noting how it has “shaken the nation”. Virus cases hit 349,000 on Saturday and show no sign of receding. The toll on the health system in India has been massive, but the variants also holds risks to the rest of the world while it will also lead to a major disruption in India’s vaccine exports, threatening vaccination programs in several countries.  

Friday’s economic data round was broadly firm. Alongside the US releases noted above, Euro area April PMIs were generally better than expected, with G10 manufacturing PMIs pointing to strengthening momentum overall.  Separately, Russia’s central bank, the CBR surprised with a bigger than expected 50bp rate hike.  Today’s data releases include the April German IFO business confidence survey; consensus expectations forecast an increase to 97.8 from 96.6 previously. In the US, durable goods orders are forecast to rise in March by 2.5% m/m following a weather-related 1.2% m/m drop in February.

The focus over the rest of the week will turn to central bank decisions in Japan, Sweden and Hungary (all on Tue) and the Federal Reserve FOMC (Wed).  Although the Bank of Canada’s shift last week will prompt a little more nervousness about G10 central bank tapering the policy meetings are likely to be largely uneventful, this week. Nonetheless, the Fed tone is likely to be more positive than in March, while in contrast the Bank of Japan may sound more cautious amid a third state of emergency in Tokyo. 

A key event this week will be President Biden’s address to a joint session of Congress.  After the hit to markets in the wake of the news of a proposal to hike taxes, markets will look for any further details.  Key data releases this week include Australia Q1 CPI inflation (Wed), US Q1 advance GDP (Thu), China’s April purchasing managers indices data (Fri) and Euro area Q1 GDP (Fri).  

Watching US Yields

Risk assets struggled to make headway last week, with technology stocks stumbling in particular.  Nonetheless, inflows into equities remain strong as more and more retail money is drawn in (perhaps signs of a near term peak).  Asian stocks started the week in positive mood despite last week’s nervousness, but equity investors will continue to keep one eye on the move in US yields.

US Treasuries continued to remain under pressure and the curve continued to bear steepen.  A combination of US fiscal stimulus hopes/expectations, vaccine progress and reduction in COVID cases, appear to be pressuring bonds. President Biden is likely to pass his $1.9 tn stimulus package in the weeks ahead, with a House vote likely this week, while the Fed continues to dampen down of any tapering talk, helping to push inflation expectations as reflected in break-evens, higher.  Indeed, this will likely be the message from a number of Fed speeches this week including Chair Powell testifying before Congress (Tue and Wed). 

Despite higher US nominal and real yields and visibly more nervous equities, the US dollar (USD) continues to struggle, failing to find a trigger to much covering of the massive short USD position still present.  We note that non-commercial FX futures positioning data (CFTC IMM) revealed only a limited reduction in aggregate USD short positions (as a % of open interest) in the latest week. Antipodean currencies led the way at the end of last week, but pound sterling (GBP) speculative positions have seen the biggest bounce over the last couple of weeks. 

Despite the USDs reluctance to rally lately, the short-term bias could shift to a firmer USD sooner rather than later, including against Asian emerging market currencies.  Indeed, several Asian currencies lost ground last week, with the Philippines peso (PHP) and Indonesian rupiah (IDR) leading the way lower.  The Asia USD index (ADXY) appears to have peaked and looks vulnerable to more short-term downside.

US economic data at the end of last week revealed that the flash estimates for the February purchasing managers indices (PMIs) stayed at fairly strong levels for both the manufacturing and services sectors.  Separately, US existing home sales posted stronger-than-expected numbers for January.

Attention this week will be on progress of passage on US fiscal stimulus as well as a number of central bank decisions beginning with China (today), New Zealand (Wed,) Hungary (Wed), and South Korea (Fri).  No policy changes from these central banks are likely.  Also of interest will be the UK’s announcement on exit plans from the current lockdown (today) and Germany’s Feb IFO survey, which is forecast to edge higher. 

US Dollar Sliding, Gold At Record Highs

Risk sentiment has turned south and the US stock rotation out of tech into value has gathered pace, with the Nasdaq ending down for a second straight week.  Gold is turning into a star performer, registering a record high today, while the US dollar continues to lose ground.  Economic activity is slowing, second round virus cases are accelerating in places that had previously flattened the curve, while US- China tensions are heating up.  Attention this week will centre on US fiscal discussions while US-China tensions remain a key focal point.

Reports suggest that Senate Republicans and the US administration have agreed on a $1 trillion coronavirus relief package.  This will be the opening offer in discussions with Democrats (who had passed a $3 trillion package in House in May), with less than a week before unemployment benefits expire.  Whether the $1 trillion on the table will be sufficient to satisfy Democrats is debatable and a figure of around $1.5 trillion looks plausible. Time is running out and pressure to reach a compromise is growing.   Further uncertainty will likely weigh on US markets in the days ahead.

US-China tensions remain a key focus for markets. Worries about a dismantling of the Phase 1 trade deal still looks premature even as China has fallen behind in terms of purchasing US imports.  The closure of the US consulate in Chengdu following the closure of the Chinese consulate in Houston will be seen as a proportionate move, that is unlikely to escalate matters.  Nonetheless, a further escalation is inevitable ahead of US elections in November, with a broad array of US administration officials becoming more aggressive in their rhetoric against China.  As such, further sanctions against Chinese individuals and companies could be on the cards.

The week could prove critical for the US dollar given that it is breaching key technical levels against a host of currencies, with the currency failing to benefit from rising risk aversion recently. While not a game changer the European Union “recovery fund” is perceived as a key step forward for the EU, a factor underpinning the euro.  Key data and events over the week include the Federal Reserve FOMC meeting (Wed), US (Thu) and Eurozone Q2 GDP (Fri) and China purchasing managers indices (PMI) (Fri).  US Q2 earnings remain in focus too.  Before these data releases, today attention turns to the German IFO survey (consensus 89.3) and US durable goods orders (consensus 6.8%).

 

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