Three Questions: Week of June 27

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:

1. Will confidence numbers flag an imminent US recession?

Consumer confidence data has deteriorated sharply in recent months and next week’s releases from the Conference Board and Institute for Supply Management are likely to extend this pattern, coming in below consensus estimates.

However, this does not necessarily mean a recession will follow - and paradoxically, tepid numbers could lift risk appetite by weakening the case for monetary tightening.

The Conference Board release will likely come in below the 100 mark, reflecting a complex mix of inflation worries, financial market volatility, and a job market beginning to fray at the edges. But the survey typically reflects views on the broader economy - not household finances, like its rival from the University of Michigan - so gasoline prices don’t carry as much weight, and it isn’t liable to fall quite as dramatically.

The Institute for Supply Management’s assessment of manufacturing conditions is also poised to fall below the consensus expectation of 55, but should remain comfortably above the contraction threshold at 50. Recent corporate earnings calls have tended to display muted optimism rather than outright dejection.

These interactions make for a set of risks that markets will have to navigate through the summer. Consumption needs to cool enough that it does not trigger an even more aggressive rate response from the Fed, but not so dramatically that it threatens to tip the economy over.

A relatively orderly slowdown in domestic growth right now would weigh on the dollar by paring back expectations of Fed tightening and improving global sentiment. It could be just what the Bad News Bulls ordered.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

2. Could Thursday’s OPEC+ meeting foreshadow a drop in inflation pressures?

On Thursday, the world’s most powerful oil cartel is expected to confirm it will lift production to pre-pandemic levels by the end of August. This won’t alleviate pressure on prices - estimates provided by the International Energy Agency suggest that a recovery in China’s economy, coupled with falling Russian exports, will leave global supply struggling to keep up with demand well into 2023.

Most countries in the 23-member alliance are already pumping nearly as much as they can. Only Saudi Arabia and the United Arab Emirates (UAE) are believed to have enough spare capacity available to increase output beyond currently-agreed levels, and - thus far - the two have rebuffed requests by the United States and its allies to open the taps wider.

But OPEC+ and the Federal Reserve are caught in a dangerous feedback loop that could lead to some form of compromise.

Why is this? Because the Fed implicitly pegged monetary policy to gasoline in recent weeks, with Chair Jerome Powell highlighting headline inflation numbers and consumer expectations - both highly correlated with prices at the pump - as factors in triggering outsized rate increases. As of April, according to the Energy Information Administration, crude oil made up roughly 60 percent of the price of a gallon of regular gasoline.

The calculus is simple: If oil prices remain high, US inflation expectations will continue to rise, and the Fed will be forced to crush aggregate demand by aggressively tightening policy. If it is too successful in this effort, global commodity prices could collapse, slashing export revenues and undoing the cartel’s market stabilization efforts.

With the US and OPEC+ facing “Mutually Assured Demand Destruction”, we suspect Saudi Arabia and the UAE will ultimately agree to exclude Russia from oil production targets and signal a willingness to pump more.

Any substantive shift in policy will have to wait until after President Biden visits Riyadh in mid-July, but signs of reconciliation might come this week. Market-based inflation expectations could be on a more slippery slope than many currently imagine.

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

3. Will Eurozone consumer price data boost the euro?

Not in any lasting way. The common currency is more likely to receive a sustained boost from delivery of the European Central Bank’s promised spread control tool or a drop in US inflation rates.

Eurozone data due on Friday will crystallize the dilemma facing policymakers. Consensus sees headline inflation of 8.5 percent year-on-year with core inflation rising 3.9 percent over the same period. Both are well above the official 2.0 percent target, so even a consensus outcome will see the central bank deliver a 25 basis point hike in July - a move that Vice President Luis de Guindos has described as a “firm commitment.” A higher print will enrage hawks pushing for a 50 basis point move out of the gate, but they may have to settle one at the September meeting, whose outcome de Guindos described as “data dependent.”

But a kneejerk rally in the euro on expectations of a more aggressive response could be hard to sustain.

As officials have pointed out repeatedly, although Eurozone employment is robust, the proximate cause of the region’s problems is a massive energy supply shock. This could get even worse if Russia’s cutbacks on gas supply precede a halt that prevents Europe from building a buffer stock ahead of winter. Such a shock would plunge the economy into recession - not the best backdrop for a strong currency, however hawkish its central bank.

Rate hikes would also benefit the euro more if there were clarity on the promised tool to control intra-Eurozone yield spreads. The more comprehensive the anti-fragmentation mechanism, the greater freedom the central bank would enjoy on rates without spillovers into sovereign credit markets.

The last (and, in our view, most likely) possible near-term boost for the euro might come from outside the region – the single currency’s best hope right now might be any sign that US growth and inflation are slowing, lowering the expected pace of Fed hikes.

Sometimes, “whatever it takes” needs outside help.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

MONDAY

USD Durable Goods Orders, May

TUESDAY

USD Advance Goods Trade Balance, May

USD Conference Board Consumer Confidence, June

WEDNESDAY

USD Department of Energy Weekly Inventories

CNY Purchasing Manager Indices, June

THURSDAY

EUR Unemployment Rate, May

USD Personal Consumption Expenditure, May

CAD Gross Domestic Product, April

USD Weekly Jobless Claims

CNY Caixin China Manufacturing Purchasing Manager Index

USD OPEC+ Meeting

FRIDAY

EUR Consumer Price Indices, June

USD ISM Prices Paid

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:

“The market-based and Sino-centric system that started to emerge towards the end of the past century is being transformed into something which, though still global, is less unitary and more costly. This should ultimately turn out to be less fragile. But the transition will be messy enough to create shocks of its own.” The Economist: The Structure of the World’s Supply Chains is Changing

“People once had economic views that didn’t dramatically and immediately shift each election.” Wall Street Journal: The Strange Art of Asking People How Much Inflation They Expect

“As central banks around the globe rapidly increase interest rates, soaring borrowing costs mean people who were already stretching to buy property are finally reaching their limits. The effects are being seen in countries such as Canada, the US and New Zealand, where once-hot residential real estate markets have suddenly turned cold. “ Bloomberg: The World’s Bubbliest Housing Markets Are Flashing Warning Signs

“Interestingly and at odds with the stereotypes about gender, the authors found the people best able to detect financial bullshit were older women with lower incomes who were not overconfident in their financial expertise. Also notable was that levels of education appeared to make no difference in the BS-detection scale. In contrast, the biggest dupes for financial nonsense tended to be young, over-confident, high-income males — similar to the demonstrated tendency for young men to be more likely to drive recklessly and under the influence of alcohol.” Evidence Investor: How Susceptible Are You to Financial Bullshit?

“Last month, Peronist President Alberto Fernández announced a new “family” of paper bills, fulfilling a campaign promise that was ostensibly delayed by the Covid-19 pandemic. This has become a rite of passage of sorts for the nation’s leaders: The latest bills will be the fourth partial or total redesign since 2011, continuing a trend now spanning three administrations across the country’s political and ideological spectrum.” The New Republic: Argentina Keeps Redesigning Its Currency, Solving Nothing

“…our results show that firms that rely more on imported inputs, in particular those invoiced in dollars, are more likely to adopt the dollar in export pricing, while larger firms are more likely to adopt the destination currency.” Liberty Street Economics: Will the US Dollar Continue to Dominate World Trade?

“Central banks urgently need to convince people that they are serious about getting inflation down. But a range of evidence suggests that changing the public’s mind could be extraordinarily difficult.” The Economist: People’s Inflation Expectations Are Rising, and Will Be Hard to Bring Down

“For close followers of Honda’s long-term offshoring strategy — and those of other large Japanese manufacturers — this came as little surprise. But it provides a timely reminder, perhaps, of why the current historic cheapness of the yen — now bobbing around a 24-year low — is not producing the effects that many investors might have come to expect." Financial Times: Why Japanese Corporates are Less Reliant on Dollar-Yen Rate for Profits