Market Briefing - Dollar Rally Pauses On Rapidly-Shifting Rate Expectations

We’d tell you that these markets have the attention span of goldfish, but that would be insulting to goldfish.

The market-implied probability of a 100 basis-point move at the Federal Reserve’s July meeting climbed over 80 percent on Wednesday and risk appetite plunged as traders responded to a surprisingly-hot inflation report and a similar-sized hike from the Bank of Canada. But sentiment improved and odds fell below 40 percent yesterday after notoriously-bullish St. Louis Fed President James Bullard told Nikkei he continued to favour a 75 basis point move. In another appearance, Governor Christopher Waller said, “The markets may have gotten ahead of themselves a little bit yesterday. We don’t want to make snap policy decisions based on some knee-jerk reaction to what happened in the CPI (Consumer Price Index) report.”

The dollar index is flat, strongly-cyclical currencies are on the rise, and equity markets are poised for a stronger open this morning as investors head into the weekend on a more optimistic footing. Two-year US yields are holding near 3.10 percent after slipping overnight, while the ten-year is at 2.92 percent.

Fed official

Both global crude benchmarks are up roughly 2 percent after a week of losses, and the Canadian dollar is grinding higher after a steep selloff in yesterday’s session. Two-year Canadian government debt instruments continue to pay more than their US equivalents, with the spread at 12.7 basis points, while the ten-year spread is at 18.6.

Italian Prime Minister Mario Draghi tendered his resignation after one of the parties in his ruling coalition pulled its support, throwing one of the world’s most-indebted economies into crisis - but head of state President Sergio Mattarella later said he wouldn’t accept it, temporarily averting the need for a snap election. Ten-year government yields popped above 3.5 percent and the spread between Italian and German debt widened to 226 points, having more than doubled since the start of the year.

The euro is trading above parity once again after briefly slipping below the dollar in high-paced trading activity yesterday. Implied volatility levels remain extremely elevated ahead of next Thursday’s reopening of the Nordstream 1 pipeline and European Central Bank meeting.

The yen is edging a little higher after Prime Minister Fumio Kishida said he had authorized the deactivation of as many as nine nuclear reactors. The move could ease Japan’s energy crunch and reduce trade deficits, removing some selling pressure on the currency.

China’s economy slowed dramatically in the second quarter as the government’s zero-Covid policies shut dozens of major cities and forced hundreds of millions into lockdown. Output expanded 0.4 percent year-on-year in the three months to the end of June, well below economist estimates and down sharply from the first quarter’s 4.8 expansion. Separate data showed home prices fell 0.1 percent in June as the all-important property sector continued to weaken, with reports circulating of an increasing number of buyers refusing to pay mortgages on unfinished homes.

US June retail sales data will be released at 8:30. Markets expect a 0.8 percent month-over-month gain on rising prices, but there is some downside risk: the Fed’s latest Beige Book suggested that some consumers are reacting to high inflation by cutting spending.

At 10:00 am, the University of Michigan's consumer sentiment index for early July is expected to tick down to 49.9 from late June’s 50. Markets are likely to focus on the long-term inflation expectations number, looking for a evidence of a rise in household price forecasts - like the later-revised number that helped trigger the Fed’s.

President Biden will meet Saudi Arabia’s Mohammed bin Salman later in the morning, but political considerations make market moving headlines relatively unlikely. If the two leaders come to an agreement on increasing oil output, the outlines will only become clear over weeks or months into the future.

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