Three Questions: Week of June 13

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 this week (please note that we will be off next week, returning on Monday, May 23):

1. Could the Federal Reserve hike by 75 basis points on Wednesday?

A short period of relative calm in markets has been shattered by Friday’s inflation print showing a broadening and acceleration in price pressures, triggering speculation about an outsized move at this week's Fed meeting.

Policymakers are likely to stick with a smaller increment for now, but the accompanying communications could set expectations for a longer series of half-percentage-point moves, or open the door to a larger hike at the July meeting - a message that might buoy the dollar and weigh on growth-sensitive assets worldwide.

Fed officials are already guiding markets in a hawkish direction. At the May meeting, Chair Jay Powell managed to temper fears that the central bank was behind the curve by setting out a catch-up rate path with half-percentage-point hikes in both June and July, telling a reporter that policymakers could “move more aggressively” if inflation pressures fail to weaken. And in early June, Board member Lael Brainard shot down a trial balloon from Philadelphia Fed President Raphael Bostic about a possible pause in September.

This Fed remains committed to working through the forward guidance channel: Mr. Powell has repeatedly expressed a reluctance to surprise markets, emphasizing the importance of expectations in implementing monetary policy. Although a hawkish dissent from St. Louis Fed President James Bullard is a real possibility, the central bank is unlikely to shift pace without preparing the ground for such a move.

And tighter financial conditions are having an impact: Rising interest rates are leading to a cooling of the housing market, equities have fallen, inventories of consumer durables are piling up, and initial jobless claims are climbing again. Eventually, this will bring prices to a peak, but it the Fed is unlikely to signal one on the horizon until well into the third quarter. The Summary of Economic Projections accompanying Wednesday’s decision will likely bring a downgrade in growth and employment forecasts, alongside a stubbornly-high inflation outlook.

The near-term problem, and one that markets have not confronted in years, is that rolling supply shocks mean less induced disinflation even as the economy slows.

The strip for an economic soft landing is getting shorter and narrower.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

2. Will May activity data bring evidence of a rebound in China’s economy?

China suffered a severe downturn in April and May as at least 45 cities, housing more than 373 million people, were put under brutal and protracted lockdowns.

A number of data releases scheduled for Wednesday are likely to exhibit the economic consequences. A marginal improvement in fixed asset investment during the month of May - mostly driven by rising infrastructure spending - is unlikely to fully reverse this year’s slowdown. Industrial production could continue its descent, albeit at a slower rate, and retail sales will almost certainly remain in negative territory.

Housing markets remain badly shaken, business confidence is weak, and overall consumer demand is suffering. The manufacturing sector is struggling to meet foreign demand.

The reasoning behind the country’s draconian approach to fighting the coronavirus pandemic remains somewhat mysterious, but is likely a reflection of low vaccine uptake among the elderly, weak herd immunity levels, and poor efficacy rates for the jabs that have been delivered. Removing mobility restrictions and abandoning testing procedures would leave the population vulnerable to a large-scale outbreak, and might result in profound embarrassment for a regime that has refused to consider importing large volumes of internationally-sourced mRNA vaccines.

A sudden reversal looks unlikely.

But authorities are taking steps to boost growth. Senior-level political rhetoric has shifted strongly toward stabilization, and the message is trickling out to far-flung reaches of the policy apparatus. Lending rates have been cut, tax rebates implemented, extended grace periods put in place, and infrastructure spending is beginning to increase. Crackdowns on property developers and technology firms have been softened. Borrowing conditions have improved, credit creation is surging, and measures of financial market activity are snapping back.

We suspect the economy is nearing a turning point, meaning that the global commodity demand outlook could be poised for another upside shock. After all, it’s never wise to underestimate the modern Chinese Communist Party’s zeal for capitalism.

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

3. Will the ECB offer reassurance on widening spreads within the Eurozone?

No. And that will weigh on the euro, offsetting a good part of the boost from the more aggressive tightening profile implicit in the pre-announcement of a quarter percentage point hike in July, or the prospect of faster rate increases thereafter.

Amid rising core-periphery rate differentials and increasing talk of a new Eurozone crisis, speeches this week from key board members Christine Lagarde, Isabel Schnabel (Germany), and Fabio Panetta (Italy) are unlikely to offer details on any plan to “close the spreads.” While the ECB will not permit a full-scale repeat of the trauma of 2010-11, near-term commitments are unlikely to go beyond talk of targeted reinvestments from maturing assets purchased during the pandemic, or vague assurances about new programs under consideration.

Asset reinvestment is unlikely to fully assuage concerns. The stock of instruments under the Pandemic Emergency Purchase Programme amounts to more than 1.85 trillion euros, but average maturities are long, and the proceeds from rolloff in any single month are too low to offset concentrated stress on single issuers.

On the positive side, core European central bankers have shed the pre-2012 belief that uncontested spread widening was a useful disciplining tool to induce fiscal and structural reform. Across the board, “financial fragmentation” is now seen as undermining efforts to deliver appropriate monetary policy.

But a hawkish contingent of policymakers does not think stress levels are high enough to act right now, and the spectre of Germany’s highest court (and its persistent warnings against debt mutualisation) will also delay immediate action.

Worries that rate increases could overtighten financial conditions for portions of the periphery are likely to remain a nagging problem for the euro until a more credible spread control mechanism is put in place. And that will require things to get worse before they get better.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

MONDAY

GBP Gross Domestic Product, April

GBP Trade Balance, April

EUR European Central Bank Speech, Guindos

TUESDAY

GBP Claimant Count Rate, May

EUR European Central Bank, Speech Schnabel

WEDNESDAY

CAD Housing Starts, May

USD Retail Sales, May

EUR European Central Bank Speech, Panetta

USD Department of Energy Weekly Inventories

EUR European Central Bank Speech, Lagarde

USD Federal Reserve Rate Decision

BRL Central Bank of Brazil, Rate Decision

THURSDAY

EUR European Central Bank Speech, Panetta

GBP Bank of England, Rate Decision

USD Weekly Jobless Claims

FRIDAY

JPY Bank of Japan, Rate Decision

USD Federal Reserve Conference on Dollar's Role

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:

“Tired, old stereotypes portray Canada as the frigid north, awash in maple syrup, hockey and politeness. In the financial world it has earned a more novel, racier reputation: as home to a giant housing bubble.” The Economist: Air Starts to Seep Out of the Bubbly Canadian Property Market

“Abe’s tenure as Prime Minister thus represented the end of Japan’s post-bubble period — a long dreamy period where corporations and families coasted on built-up wealth. The country is back to the grind.” Noahpinion: The Japan That Abe Shinzo Made

“Productivity, which is defined as the value of goods and services produced per hour of work, fell sharply in the first quarter this year, the government reported this month. The quarterly numbers are often volatile, but the report seemed to dash earlier hopes that a productivity revival was finally underway, helped by accelerated investment in digital technologies during the pandemic.” New York Times: Why Isn’t New Technology Making Us More Productive?

“When the experiment was up and running and we started to see the data, we were astounded to see that productivity was up, not down. Maybe in 2022 it doesn’t seem surprising, but back then in 2011, it was pretty amazing. Productivity was up 13% for the people working from home, which is a huge improvement.” Bloomberg: Are Workers More Productive at Home?

“Susan Kirsch is a 78-year-old retired teacher who lives in a small cottage home in Mill Valley, Calif., on a quiet suburban street that looks toward a grassy knoll. A Sierra Club member with a pesticide-free garden, she has an Amnesty International sticker on her front window and a photograph on her refrigerator of herself and hundreds of other people spelling “TAX THE 1%” on a beach. The cause that takes up most of her time, however, is fighting new development and campaigning for the right of suburban cities to have near total control over what gets built in them." New York Times: Twilight of the NIMBY

“Since Russia’s invasion of Ukraine, over 20 countries around the world have imposed restrictions on food exports, including export licences and taxes as well as outright bans.” Reuters Graphics: The War in Ukraine is Fuelling a Global Food Crisis

“The oil market is projecting a false sense of stability when it comes to energy inflation. Instead, the real economy is suffering a much stronger price shock than it appears, because fuel prices are rising much faster than crude, and that matters for monetary policy." Bloomberg: Sorry, But for You, Oil Trades at $250 a Barrel

“But how powerful an influence do the actions of central banks actually have on inflation? A new paper - straight out of the radical confines of the Fed - suggests that the impact of the “Volcker shock” has been vastly overplayed, and that the inflation of the 1970s was solved through de facto class war and the degradation of the union movement rather than monetary policy.” Financial Times: Class War > Rate Hikes