Three Questions for the Week Ahead: Week of July 25

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we'll be watching: 

Question 1: What will Wednesday’s Fed decision mean for markets?

The world’s most powerful central bank is virtually certain to hike rates by 75 basis points this week. After several prominent hawks poured cold water on the prospect of a larger move, markets are well-prepared, and a last-minute communication adjustment looks unlikely. Instead, traders are likely to focus on the message delivered in the statement and the post-decision press conference. 

We believe policymakers have moved on from worrying about a wage-price spiral and will acknowledge recent data showing a stabilization in consumer inflation expectations. Mounting recession risks could also make an appearance. 

But it is far too soon to declare the hiking cycle done - Chair Powell has repeatedly said he needs to see a succession of declining month-on-month consumer price data prints before considering a shift in direction.  

Policymakers will maintain an overtly-hawkish rhetorical stance, keeping front-end rate expectations elevated as they seek to counter still-present inflation risks. Officials are also likely to downplay recession worries, instead casting decelerations in housing and employment as a welcome downshift to a more sustainable pace. 

In the press conference, Mr. Powell may emphasize the importance of incoming data, but with rates at 2.5 percent and inflation seemingly rolling over, we think he will also signal greater comfort on the economic outlook. This could reduce market sensitivity to single data prints and help lower short-term interest rate volatility.

If a pivot comes, it will likely occur in the September macroeconomic and rate projections - the dot plot - where committee members could signal growing confidence in bringing inflation down to target, while expressing emerging doubts about the economic outlook. To some extent, this aligns with current market pricing - investors see the central bank hiking 100 basis points over the three autumn meetings and a pause before cuts start in 2023. 

A meeting without too many fireworks could give other currencies respite from a rampant dollar - at least until the Jackson Hole central bankers’ jamboree in August sets out more signposts.

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

Question 2: Will US data bring official confirmation of an economic slowdown? 

The American economy is losing momentum as consumer spending patterns normalize, falling sentiment levels weigh on investment, and financial conditions tighten. This week is likely to deliver more evidence of a downturn: 

On Tuesday, the Conference Board’s measure of consumer confidence is likely to deteriorate further, with recession talk and worsening job market conditions combining to offset an improvement in gasoline prices. 

Durable goods orders on Wednesday could illustrate weakness in non-transport, non-military business investment, suggesting that the corporate sector is battening down the hatches amid higher costs and significant demand uncertainties. 

Thursday’s first cut of second quarter gross domestic product is expected to show a 0.4 percent expansion, but many market participants are braced for an inventory-, and investment-driven decline. Overall consumption likely remained robust and a shift in spending patterns narrowed the country’s goods trade deficit in the quarter, but residential investment fell, and businesses addressed “bullwhip” effects by cutting investment and reducing inventory accumulation. 

On Friday, the latest consumer spending data along with two of the Federal Reserve’s preferred inflation measures will be released. We think consumer outlays likely grew in June as gasoline prices kept rising and spending on intangible products rebounded, and personal income probably continued to gain. The core personal consumption expenditures index is expected to hold stable at 4.7 percent year-over-year, although a broadening in service cost gains could lift the measure. Labor costs, as measured through the wages and salaries component of the employment cost index, are expected to slow, underlining a nascent moderation in underlying inflation pressures. 

Taken together, these data points might not meet the official definition of a recession - a downturn in employment and personal income is generally needed to trigger the recession dating process - yet the headline impact could reinforce already-deteriorating sentiment levels among businesses and consumers, pushing the economy closer to an outright contraction. 

In the perverse logic that drives the modern financial system, this might be welcome news for foreign exchange markets: by weakening momentum behind the Fed’s monetary tightening campaign and narrowing expected interest differentials, signs of a downturn in the United States could give other currencies some breathing room. 

Data released yesterday showed speculative bullishness on the greenback hit its highest level since mid-May last week, but we’re increasingly convinced that - if it hasn’t already passed - a peak in the dollar is near. 

-  KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

Question 3: How might a looming Italian election impact the euro? 

After a shock government collapse, Italy will head to the polls on September 25. We believe this will contribute to elevated levels of implied volatility, but shouldn’t result in a sustained directional impact on exchange rates. 

Mario Draghi’s departure represents a huge loss. The former central banker brought credibility and discipline to the role, and his problem-solving skills offered the country’s best chance for successfully implementing the reforms needed to unlock another 200 billion euros in European Union aid funds. 

But elections were already due next spring, and party preferences are largely locked in. On current polling, the parties of the right – Brothers of Italy (FdI), Lega, and Silvio Berlusconi’s FI – are set to have the strongest showing. Conversely, the unpredictable leftish-populist Five Star Movement (M5S) has shrunk, reflecting its own incoherence and defections from the ranks. 

In contrast with the positions that sparked market panic in the early days of the M5S/Lega coalition in 2018, euroskepticism is a mostly-spent force in Italian politics. M5S leadership has made its peace with the common currency; a smaller Lega has given up its flirtation with exit talk and returned to its roots as a conservative party of Northern Italian business; and the hard-right FdI (now the biggest party on the right) cares more about migration and cultural issues.

And the European Central Bank’s new spread control tool offers powerful incentives to stay on the right side of the European Union. With fiscal and monetary support available to those who maintain harmonious relationships with other members, the potential returns to a euro-hostile strategy on the campaign trail are shrinking. 

We think this combination of offsetting forces could keep the euro’s gains capped through the summer months, even as shrinking rate differentials put a floor under the currency. The risk represented by dysfunctional Italian politics is small - at least relative to Gazprom’s trapdoor. 

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

TUESDAY

USD Conference Board Consumer Confidence, Early July

WEDNESDAY

USD Advance Goods Trade Balance, June

USD    Durable Goods Orders, June

USD    Department of Energy Weekly Inventories

USD    Federal Reserve Rate Decision

THURSDAY

USD Gross Domestic Product, Q2

CAD    Survey of Employment, Payrolls, and Hours, May

USD    Weekly Jobless Claims

FRIDAY

EUR Gross Domestic Product, Q2

EUR    Consumer Prices, July

MXN    Gross Domestic Product, Q2

CAD    Gross Domestic Product, May

USD    Personal Consumption Expenditures, June

USD    Employment Cost Index, Q2

USD    University of Michigan Consumer Sentiment, July (Final)

COUNTERPARTIES

Some of this week's most interesting and informative reads on the state of the global economy:

“Yet these past 20 years have been the era of lower-than-ever financing costs, first because of market exuberance, then thanks to central banks’ ultra-lax monetary policy. And what do we have to show for all that cheap credit? Two lost decades for investment. As economics writer Annie Lowrey concisely puts it, “we blew it”.

Financial Times: The Investment Drought of the Past Two Decades is Catching Up With Us

“If you find something that is true in more than one field, you’ve probably uncovered something particularly important. The more fields it shows up in, the more likely it is to be a fundamental and recurring driver of how the world works.”

Collaborative Fund: Little Ways the World Works

“Perhaps because Beijing seems to be able to defy financial gravity, fewer people these days worry that its ballooning debt could unleash a systemic crisis. But there are many warning signs indicating that China may face a debt reckoning soon.”

Nikkei: China's Debt Bomb Looks Ready to Explode

“New data released on Saturday by China’s National Bureau of Statistics shows that youth unemployment hit 19.3 percent in June.”

Grid: China Has an Unemployment Problem

“What if instead inflation remains stubborn and rates have to rise a lot more? That would spell trouble for an economy where asset values, private and public debt have risen on the assumption that rates will remain historically low.”

Wall Street Journal: Interest-Rate Pain From Higher Inflation Has Barely Begun

“A Big Mac costs ¥390 in Japan and US$5.15 in the United States. The implied exchange rate is 75.73. The difference between this and the actual exchange rate, 137.87, suggests the Japanese yen is 45.1% undervalued.”

The Economist: Dollar-Euro Parity May be Justified. But the Yen Looks Cheap as Chips