Three Questions: Week of August 8

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 might inflation data mean for Fed policy?

The week ahead will bring three critical inflation-related data points, but attention will focus largely on the consumer price print due Wednesday. It is expected to show headline prices rising by 0.2 percent month-on-month in July (versus June’s 1.3 percent shocker), and the core measure (excluding food and energy) climbing 0.5 percent, down from 0.7 percent in the prior month. These numbers are clearly inconsistent with the Federal Reserve’s annual 2.0 percent target, and Chair Jerome Powell has said he wants to see “a series of declining monthly inflation readings” as an indication the target can be reached by 2024.

That test has not been met. Powell has made it clear that despite risks to growth, he sees inflation as the real enemy. Recent speeches have framed the Fed’s next meeting in September as a close choice between a 50- and a 75-basis point increase, and Friday’s blockbuster employment report has tilted the odds in favour of a bigger move. Philadelphia Fed President’s Raphael Bostic once-mooted September “pause to take stock” is long dead.

The headline consumer price index could come in below expectations - the national average gasoline price has dropped almost 18 percent since its June peak, and seasonal effects could play an important role. Plunging shipping and commodity costs might also exert drag on Thursday’s producer price index, and weigh on Friday’s long-term inflation expectations measure from the University of Michigan.

In contrast, core price growth could remain elevated, with shifting consumer preferences - from goods to services - putting upward pressure on a number of key categories as overall household wage gains lift spending levels.

A broadening in price pressures could add more fuel to market expectations for a front-loaded tightening cycle, raising terminal rate forecasts and lifting the dollar - in a repeat of the knee-jerk reaction seen repeatedly in recent weeks. But this would also be read as a hawkish policy mistake, further inverting the yield curve, and hitting growth-sensitive currencies hard.

Inflation may have peaked, but has lost none of its capacity for surprise.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

Question 2: How will Thursday’s Banxico meeting impact the peso?

Mexico’s central bank is universally expected to raise rates by 75 basis points to 8.50 percent. It will be the second hike of that magnitude in a row, continuing a tightening cycle that has added 450 basis points in a little over a year.

The bank’s five voting members are largely agreed on fighting inflation. The most recent figures showed headline prices rising at 8.2 percent year-on-year and core at 7.6 percent – well above Banxico’s 3.0 percent target.

Most of the board also believes in keeping up with the Federal Reserve, maintaining a constant yield spread between the peso and the dollar. Erstwhile dove Gerardo Esquivel surprised markets at the last decision, joining the majority in voting for a 75 basis-point hike, and is expected to do so again - his objections to the policy path in late 2021 and early 2022 found him alone, unable to persuade other members. Little seems to have changed.

With little doubt among Banxico-watchers about the size of this increase, there will be more attention to any hints provided on the future rate path. According to current market pricing, the tightening cycle will slow from here, peaking at 9.5 percent late this year, with incremental moves largely in line with the Fed. The statement could make dovish allusions to easing inflationary and rate pressures in developed markets — potentially justifying a slowing in Mexico’s own pace — but any such language will be cautiously hedged.

The strategy of shadowing the world’s powerful central bank has served Mexico well this year, with the peso eking out some gains against a rampant dollar. Barring a very unlikely dovish mistake, Banxico policy should remain a source of support for the exchange rate - as long as there are no nasty upside surprises in US inflation.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

3: Could the dollar move back to the decade highs reached in mid-July?

Quite possibly.

Friday’s non-farm payrolls report exposed a truth that had been obscured behind deeply-flawed growth data and sentiment surveys: with job numbers, hours worked, and wages rising simultaneously, American workers are experiencing a rapid increase in aggregate income - sufficient to power higher levels of household spending and raise prices across the economy.

If this week’s core inflation print remains searingly hot, traders could begin to position for an unmistakably-hawkish turn from Federal Reserve Chairman Jerome Powell at the Jackson Hole conference in late August, putting renewed momentum behind the greenback.

But the global economic backdrop is also evolving. The conflict in Ukraine has settled into a war of attrition and tensions over Taiwan remain largely rhetorical, limiting demand for safe haven assets. Oil prices are coming under sustained pressure, eroding the terms-of-trade advantage that set North America apart through the early part of the year. Global central banks are working assiduously to narrow interest rate differentials, hiking rates to defend currencies and defeat domestic inflation pressures. Growing odds on a policy mistake are keeping a lid on long-term US yields.

And the broader market environment looks uncomfortably homogenous: emerging market currencies are weak, near-apocalyptic event risks are priced into the euro and pound, positioning against the yen remains decidedly bearish, and investors are running scared in China.

Traders are piled into one side of the boat, expecting prevailing trends to continue.

A rally in the dollar cannot be ruled out in the near term, but we would caution that the risk and reward balance in currency markets is gradually tilting toward other majors. As David Swenson —Yale University’s spectacularly-successful endowment manager — once put it: “Overweighting assets that produced strong past performance and underweighting assets that produced weak past performance provides a poor recipe for pleasing prospective results”.

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

CATALYSTS

WEDNESDAY

USD Consumer Price Index, July

USD Department of Energy Weekly Inventories

THURSDAY

USD Weekly Jobless Claims

USD Producer Price Index, July

MXN Bank of Mexico, Rate Decision

FRIDAY  

GBP Gross Domestic Product, June

GBP Trade Balance, June

USD University of Michigan Consumer Sentiment, August

USD Baker Hughes Weekly Rig Count

COUNTERPARTIES

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

“European countries are on track to reach a gas storage filling target by the start of this winter, but the cost of replenishing stocks will be over 50 billion euros ($51 billion), 10 times more than the historical average of filling up tanks for winter.” Reuters: European Gas Storage On Track to Meet Target But At a Cost

“But the economy isn’t a machine that obeys the laws of physics. The relationship between its inputs and actors changes over time, just as human society does. And right now, thanks to the pandemic and how advanced economies responded to it, we’re in a very strange place indeed. The typical relationships between one signal from the economy and another have diverged in surprising ways.” Quartz: The Weird Contradictions Rendering the US Economy Inexplicable

“A government that cannot ensure the steady supply of food and energy at prices its citizens can afford to pay is likely to face political and social unrest and unlikely to remain in power for long. Because they threaten the stability of the state, famines and fuel shortages have always been a special concern for the ruling class.” Reuters: How To Respond to Food and Energy Shortages - A Short Guide for Policymakers

“AWS further protects customer data from outsiders, including Amazon’s own employees, via encryption and microchips that keep the functions used by AWS and those used by clients physically separate, Mr. Maxwell said. Yet one of AWS’s greatest competitive advantages isn’t a piece of technology: It is the U.S.’ rule of law and clear-cut legal framework governing data hosted by U.S. providers, Mr. Maxwell said. They are “a tremendously powerful advantage for any American company that works in this space.” Wall Street Journal: Big Tech Is the West’s Surprise Weapon in Competition With Russia, China

“At this stage, inflation is increasingly embedded in price growth, which is fueling wage growth that is in turn fueling price growth. This worrisome process – some call it a “wage-price spiral,” but I prefer “wage-price persistence” – is underwritten by short-term inflation expectations, which have risen markedly.” Project Syndicate: America’s Wage-Price Persistence Must Be Stopped

“Between 1998 and 2020, a rise in China’s firm births is correlated with higher firm exits and slower growth one and two years later for U.S. firms in corresponding sectors. Sectors targeted and subsidized through China’s Five-Year Plans experience a surge in new firms, while the corresponding sectors in the U.S. see declines in firm births, output, employment, and earnings. China’s earlier Five-Year Plans tend to displace labor-intensive sectors in the U.S., while more recent ones displace capital-intensive sectors in the U.S.” Stanford CCEI: How China’s Government Interventions Shape U.S.-China Industrial Competition

“Whackflation is an oscillation between big booms and busts. It’s big price spikes followed by price falls. It’s the uncomfortable position in which we watch complex systems that have been given a big whack by the global pandemic try to stabilize themselves.” Bloomberg: Why We Should All Start Talking About ‘Whackflation’

“From the harried canyons of Wall Street to the outwardly calm boardrooms of Zurich, the world's financial centers experienced a whiff of panic last week. In two days of frantic trading, the price of gold on the London exchange soared a breathtaking $50 per oz. to $447 at one point; then it plunged back down almost as steeply, closing the week at $385. Silver, platinum and copper also gyrated wildly. Said a New York bullion trader: "The market's gone bananas." Time: Shrinking Role for U.S. Money (from 1979)