Three Questions: Week of July 11
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: How will Wednesday’s inflation data influence expectations for the July Fed meeting?
US consumer price data due this week is projected to show month-on-month inflation accelerating to 1.1 percent, a pace far above the Federal Reserve’s comfort level. For all the market chatter about growth risks, this is virtually certain to buttress the case for a 75-basis point hike in July.
Minutes from the central bank’s June meeting pointed to high headline inflation as a major factor in triggering a larger hike, with officials worrying elevated prints could contaminate behavior and unleash a wage-price spiral. Chair Jerome Powell said, “it would be bad risk management to just assume … longer-term expectations will remain anchored indefinitely in the face of persistent high inflation.”
Market-implied odds on a three-quarter-point increase are currently holding near 92 percent, and measures of fixed-income volatility are close to multi-year highs as traders brace for tighter financial conditions. This is a gift horse the Fed will not look in the mouth - particularly after having to adjust market expectations in the days ahead of the last meeting. Policymakers have every incentive to communicate a commitment to bringing down inflation, to ratify market pricing, and potentially lower volatility by reducing perceived sensitivity to single data points. As Board member Christopher Waller said on Thursday, “The market is expecting rate hikes. Let’s get it done.”
The message is clear: inflation has become the Fed’s the number one enemy, headline price measures are the new target, and officials want to see a “series of declining monthly readings” before changing course. This week’s number will come nowhere near that threshold. 75 basis points in July is practically baked in.
- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST
Question 2: Will the euro slip below parity with the US dollar?
At this point, it seems only a miracle could prevent the euro’s fall through the biggest round number in foreign exchange markets.
The fundamental picture is clear - and it is ugly. A global energy shock is driving a spectacular widening in Europe’s current account deficit. Economic activity indicators are turning down as households and businesses deal with skyrocketing costs. The European Central Bank is lagging the Federal Reserve’s tightening pace as it seeks to simultaneously cut inflation, address fragmentation risks, and avert a slowdown. Interest differentials are tilting inexorably against the currency.
Speculators are piling on, with bearish bets against the common currency hitting the highest level since November. Hedgers are rushing to protect themselves, with options markets seeing increased demand for protection levels as far down as the 90-cent level.
From a technical standpoint, it’s hard to know how far a move might go. The rise of algorithmic execution has diluted the effect over time, but studies have long shown human traders tend to place stop loss buy orders just above round numbers, and stop loss sell orders just below them, leading to a rapid acceleration in price action when a big number is broken. If parity is breached, a rapid drop down to the 95-cent level - or below - is well within the realm of possibility.
This could inflict serious pain on firms with unhedged exposures, and will inevitably trigger thousands of alarmist headlines in the financial press.
But to a large extent, the euro’s decline has really been about the dollar’s rise: the greenback has outperformed every major currency this year on widening rate differentials, a degree of energy independence, and significant safe-haven flows – three factors that could lose traction in the months ahead as global growth gaps begin to narrow and energy prices subside.
And the euro-dollar exchange rate has lost importance over time as Europe has deepened its relationship with other trading partners. On a broad nominal trade-weighted basis, the euro fell just 2 percent in the first half, remaining 11 percent higher than in August 2012 - when Mario Draghi famously pledged to do “whatever it takes” to keep the common currency project together.
For now, the euro’s descent has a higher probability of continuing than not, but the move might not prove as durable - or as meaningful for the real economy - as the headlines would have you believe. No miracles required.
- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST
Question 3: Will the booting of Boris boost the pound?
On Tuesday, Boris Johnson said he would resign as prime minister, triggering a rally in the pound against both the dollar and the euro. Although none of Johnson’s potential replacements shares his aptitude for chaotic leadership, the political turmoil is far from over, and we think the currency has already seen the best of its post-Boris pop.
Johnson, who intends to remain in Parliament, is expected to serve as prime minister until the party formally picks a new leader in two stages: Conservative Members of Parliament will appoint two candidates, and then the broader party membership will select a winner. This second stage will likely be completed only in September.
In the short-term, a lame duck will be in charge, making it difficult to move forward with broad changes in policy. The party remains divided on fiscal matters, with some leadership aspirants supporting tax cuts while others worry about deficits. Relations with the European Union are unlikely to ease, with candidates indulging hardline Euroskepticism among the party rank and file. The Tories are behind in the polls, but a new leader could wager on a “honeymoon” early election, making markets wonder about a Labour government. And, just to add to the drama, London will have to decide on how to respond to the Scottish government’s plan for another independence referendum in October 2023.
Conditions at the Bank of England are hardly better, where there are disagreements on how to deal with a stagflation problem that has been exacerbated by the impact of Brexit on both supply and demand conditions.
Johnson’s departure may remove one irritant, but the pound remains a currency managed by a divided central bank in a divided country run by a divided political party. We believe sterling will remain tarnished.
- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST
CATALYSTS
TUESDAY
GBP Bank of England Speech, Bailey
CNY Trade Balance
WEDNESDAY
GBP Monthly Gross Domestic Product, May
USD Consumer Price Indices, June
CAD Bank of Canada Rate Decision
CAD Bank of Canada Monetary Policy Report
USD Department of Energy Weekly Inventories
THURSDAY
USD Weekly Jobless Claims
CNY Gross Domestic Product, Q2
FRIDAY
USD Retail Sales, June
CAD Existing Home Sales, June
USD Baker Hughes Weekly Rig Count
COUNTERPARTIES
Some of this week’s most interesting, insightful and off-beat reads on the state of the global economy:
“Today, something highly unusual is happening. Economic output fell in the first quarter and signs suggest it did so again in the second. Yet the job market showed little sign of faltering during the first half of the year. The jobless rate fell from 4% last December to 3.6% in May.” Wall Street Journal: If the U.S. Is in a Recession, It’s a Very Strange One
“Cartel bosses seem to have read their Ricardo. Globalisation — supposedly in retreat elsewhere — is alive and kicking when it comes to illegal drugs.” Financial Times: The inflation-proof economics of drug dealing
“Tighter financial conditions are both an intentional goal and necessary byproduct of efforts to pull inflation down using monetary policy. But the obvious risk is that worse financial conditions could amplify recession risk, increase the chance of a financial crisis, or hinder efforts to increase long-run economic capacity. Though financial conditions are not at their worst levels in recent history (2008, 2012, arguably 2016, and early 2020 were all worse) the pace of change is alarmingly fast, and watching out for further deterioration in financial conditions will be critical to spotting a possible recession.” Apricitas Economics: Financial Conditions are Worsening
“Separating the underlying data from the personal consumption expenditures price index into supply- versus demand-driven categories reveals that supply factors explain about half of the run-up in current inflation levels. Demand factors are responsible for about one-third, with the remainder resulting from ambiguous factors.” FRBSF: How Much Do Supply and Demand Drive Inflation?
“More than one-third of Americans believe the economy is now in a recession, according to a poll last month by CivicScience.” Bloomberg: Wall Street Says a Recession Is Coming. Consumers Say It's Already Here
“In a low-inflation regime, relative price changes, even the salient ones, tend to fade away without leaving a noticeable imprint on aggregate inflation. Hence, the regime is, to a certain extent, self-equilibrating. As such, it tends to become entrenched unless subjected to major shocks that are not met with a sufficient policy response. By contrast, a high-inflation regime does not have such desirable properties and inflation becomes increasingly sensitive to relative price shocks – including large exchange rate depreciations. It is therefore more likely to increase further.” Bank for International Settlements: Inflation: a look under the hood
“In northern Shaanxi province, where urban workers make an average of Rmb52,000 ($7,760) per year, Xi’an University of Science and Technology is offering Marxism PhDs an annual base salary of Rmb200,000, a Rmb20,000 signing bonus and free housing.” Financial Times: China’s Marxism majors prosper amid labour market woes
“Asset price inflation and the consequent rise in the wealth of the 1% is so normalised, it is scarcely discussed – even by the 99%. But we have lived through forty years of what Whitney Baker rightly calls “hyperfinancialisation” and an orgy of money-funded speculation. “We know nothing but relentless asset appreciation.” Prime Economics: Central bankers, inflation “cousins” & the real threat to the global economy