Investors continue to hold on to the possibility of a potential 50 basis point cut being delivered by the Federal Reserve on Wednesday. The labor market slowdown would justify a jumbo cut, but can Powell rally the FOMC behind his cause?
Financial markets displayed the typical behavior we would expect given the dovishness expected from the Fed over the next 3-4 meetings. Global equities have recovered some ground this week and bond yields continue to decline to new lows.
The US dollar has felt the impact of two weak back-to-back job reports and has already lost the gains made after the slightly stronger CPI report this week. USD/JPY pushed lower, trading just above 140 and near the lowest level since December 2023.
The presidential debate has not garnered much market attention apart from some moves immediately following the event as the macro and monetary picture continues to overshadow politics.
The doom and gloom narrative continues to hang over Germany and China. Both countries are going through structural change of their growth models, which lasted for the better half of the last three decades. Macro momentum remains weak.
The European Central Bank lowered its benchmark policy rates by 25 basis points. However, it is unlikely if the rate reduction will be followed by another easing in October. Inflation is coming down, but wage growth remains elevated.
We are not expecting a change in policy from the BoE, BoJ or PBoC next week.
Global Macro
Investors can’t give up on fifty
Fed still unsure. The US dollar surrendered its post-CPI gains from Wednesday as traders upped their wagers on a half point rate cut by the Federal Reserve next week. Despite some upside surprises in both core consumer and producer price inflation data seen this week, suggesting a quarter-point cut is more likely, media reports and a dovish shift from former Fed member Dudley implied the Fed’s decision would be a close call.
Kamala comes out on top. The first presidential debate between former President Donald Trump and current Vice President Kamala Harris in Philadelphia is over. A lot of open questions regarding policy have been left unanswered as both candidates agreed, in principle, to another debate sometimes before November 5th. It might be ironic that Taylor Swift’s endorsement of Kamala Harris, who is seen as having come slightly on top in the debate, might have had a bigger impact on voting intentions than the wrangle with Trump. Markets tend to agree with that view. Betting markets now see a slight bias toward Harris (52-56%) vs. Trump (48-44%) winning the election.
Core stickiness. The CPI report was the last big data release amidst the blackout period before the much-anticipated Fed meeting. The headline rate slowed for a fifth consecutive month to 2.5% in August, the lowest since February 2021 and the six-month annualized CPI measure dropped below 2% for the first time since 2020, underscoring the progress made on inflation. However, it was the core measure which gained most attention as it registered a small beat versus the consensus, rising 0.3% on the month versus an expected 0.2%. The rise in super core inflation is also noteworthy.
Global Macro
Yen, China, and Draghi
Yen above all. Bank of Japan officials continue to uphold their hawkish bias, fuelling the narrative of a potential rate hike coming before year end. This expected policy normalization coupled with US yields falling to 17-month lows have dragged USD/JPY to a new 2024 low point at 140.50¥. The Japanese yen is currently tearing through FX markets, having appreciated against 98% of the world’s currencies since the beginning of the second half of 2024. Going forward, risks are more neutrally balanced for the yen. Asset managers turned net-bullish on the currency for the first time this year and with 270 basis points of Fed cuts already priced into futures for the next 24 months, the room for dovish repricing is limited. A slow appreciation to below the 140¥ mark remains our baseline.
What more can China do? Most analysts covering Chinese macro and monetary policy have been puzzled by the lack of stimulus introduced this year. We have recently argued that both fiscal and monetary policy just don’t have the firepower they once had. (1) Financial conditions are the most accommodative since records began. (2) Official lending rates are at record lows. (3) The reserve requirement ratio is the lowest since 2007. (4) And finally, the budget deficit averaged just shy of 7% in the years following the pandemic. So, policy is supportive by any stretch of the imagination, just not enough to bring back growth to levels we are used to from China.
Draghi doom. German productivity has not grown since 2007, while it increased by almost 30% in the United States. Mario Draghi is right about calling the lack of productivity growth an existential challenge for Europe in his report published this week. The initial failure to capitalize on the internet at the end of the 1990s, the Global Financial Crisis, and the pandemic have left the continent in the shadow of the US and China. Europe is now running the well recognized risk of losing global relevance as it fails to incorporate new technological advancements like AI into its growth model.
Regional outlook: Eurozone
ECB lowers rates, but remains focused on inflation
ECB cuts rates second time in 2024. The ECB cut the deposit facility rate by 25bps to 3.5%, in line with market expectations. Additionally, the rates on the main refinancing operations and the marginal lending facility were lowered to 3.65% and 3.90%, respectively, effective from September 18th.
Growing growth risks not yet sufficient to move the needle. In terms of projections, the inflation forecast remained unchanged at 2.5% for 2024, 2.2% for 2025, and 1.9% for 2026, though a short-term rise in inflation is anticipated as the effect of earlier energy price declines fades. Core inflation is expected to drop from 2.9% in 2023 to 2.0% by 2026, despite slightly elevated services inflation. On the growth front, the ECB revised down its forecasts by 0.1 percentage points for 2024, 2025, and 2026, reflecting weaker growth prospects. Despite acknowledging downside risks, President Lagarde and the ECB maintain confidence that momentum will improve, driven by a recovery in real incomes, though this has remained a weak spot thus far in 2024. Service inflation remains a concern for the committee, posing an ongoing risk to the inflation outlook.
Budget challenges may keep French assets under pressure. After a long summer of uncertainty, Macron selected Michel Barnier as France’s new prime minister whose most urgent task is the budget bill for 2025, originally due by 20th September. The French government has already requested an extension to the deadline, a request that has not yet bothered investors too much given the focus of the approaching first Fed rate cut next week. However, Barnier has no majority in the Parliament, and faces a National Assembly with many lawmakers outright hostile to him, or at best demanding policy concessions in exchange for not toppling the government in a no-confidence vote. Signs of potential difficulties in arriving at a budget may flare up the OAT-Bund yield spreads from the current levels, which may temporarily weigh on the euro.
Week ahead
Fed to cut rates, but by how much?
Fed opens the floodgate. Investors just can’t let go of the possibility that the Federal Reserve could raise interest rates by 50 basis points on Wednesday. While not the base case, higher than expected inflation figures and a push for a jumbo cut by prominent Fed watchers have brought the topic back into the center of discussion this week. The Bank of England and PBoC will likely hold rates unchanged for now but more easing seems to be in the pipeline. We are watching out for any comments from the Bank of Japan regarding the possibility of an earlier than expected rate hike in October.
25 or 50? The Federal Reserve is expected to cut interest rates by 25 basis points, but the possibility of a larger move can not be ruled out. The central bank might opt for a smaller cut and wait for more data to confirm the need to go 50 next month or the month after. The median dot-plot will be revised down, likely showing three cuts (75bp) in the pipeline for 2024 and should remain below the market pricing of 100 basis points of cuts. The retail sales and industrial production figures before the FOMC decision will be watched as well.
No change, lots of nuance. The Bank of England, Peoples Bank of China and Bank of Japan are expected to leave policy rates unchanged. British policy makers have welcomed the recent bout of disinflation, but the level of wage, rent and services inflation leaves enough room for them not to ease policy next week. In Japan, the inflation report preceding the BoJ decision might spur bets of another October rate hike. Core inflation is set to accelerate from 2.7% in July to 2.8% in August.
FX Views
Fed pricing steering FX
USD Pops and drops. Despite two above-consensus US inflation prints this week, helping the dollar briefly pop higher with US yields, a fresh round of dovish Fed bets, bringing a 50-basis point cut back on the table, saw the dollar erase its earlier gains. Even if a half point cut isn’t delivered, a dovish 25bp move could lead to extended dollar weakness, particularly against the Japanese yen given the BoJ is expected to hike rates again before year-end. The over 2% decline in USD/JPY this week has been the major drag on the dollar index (DXY), which has made two failed attempts to recover above 102 recently. The DXY could be at risk of a deeper drop it if breaks below its 200-week moving average, which it’s been above since 2022. Amidst the uncertainty around the Fed’s outlook and the looming US election, implied 3-month volatility for the US dollar is nearly as high as it’s been since the regional-banking crisis in early 2023. The main dollar bearish drivers remains cyclical considerations and more dovish Fed expectations, but US politics might play a bigger role as the November election draws nearer.
EUR Hawkish ECB keeps euro bid. Having started the week in the red, the euro has rebounded to the $1.11 level, supported by a less-dovish-than-expected ECB and rising dovish bets on the Fed. The risks are increasingly skewed towards heightened speculation of a half-point rate cut by the Fed, which could push EUR/USD higher. This shift is reflected in the narrowing front-end Germany-US yield spread, now at 16-month lows. Even a more dovish 25bp move by the Fed—accompanied by signals of larger easing or potential 50bp cuts ahead—would likely keep the euro well-supported, as any short-term dollar gains could be reversed with the expectation of deeper cuts in subsequent meetings this year. In the options market, EUR/USD short-term risk reversals have seen their steepest repricing since the August stock market selloff, rising to 0.55 vol in favour of euro calls. Given this backdrop, a break above $1.110 for EUR/USD seems likely, though resistance at the $1.12 level remains a key hurdle for now.
GBP All eyes on inflation and BoE. The British pound slumped to its lowest in three weeks versus the US dollar after UK GDP data posted no growth in August. But GBP/USD managed to hold onto its key psychological handle of $1.30 and climbed back above $1.31 amid USD selling. Seasonals aren’t favourable for sterling though as September has, on average, been the worst month of the year for GBP/USD since 2000. Could we see the pair end what has been the longest stint without a 1% monthly decline since 2014 if rate differentials continue to move against the pound? UK-US rate differentials have fallen from 1-year highs recently due to money markets adding to wagers on BoE easing this year, but we still anticipate the BoE will remain the most hawkish among G3 central banks. Hence, sterling retains an attractive yield advantage over its peers. The premium of UK government bond yields over those in the rest of the G10 is 120 basis points at present, compared with an average of just 30 basis points over the last 10 years. This supports our upside bias on sterling through year-end. Nevertheless, the short-term risk to this outlook may grow if UK inflation data next weeks prompts a further rise in BoE easing bets.
CHF Demand subsiding on jumbo cut bets. The Swiss franc endured its first weekly loss in four against the euro and US dollar this week. After the franc’s rally to the strongest level in almost a decade, money markets increased bets that the Swiss National Bank (SNB) might deliver the first jumbo interest-rate cut by a major central bank this year. A strong franc is seen as hampering the country’s exports and lowering the price of imports at a time when inflation is already well within the SNB’s target — and near a three-year low. Hence, traders have been raising their bets on the prospect of a 50-basis point cut with market pricing now reflecting a 30% chance, up from zero just a month ago. Ultimately, if the SNB takes a more dovish steer, either through the rates or currency market intervention, this is bound to alter the prevailing momentum of the franc. Perhaps this week’s price action marks the start of an extended swissy downturn? A key risk to this outlook though is a further unwinding of carry trades, which benefits low yielding funding currencies like the franc.
CNY China’s deflation woes deepen: Yuan under pressure. China’s August PPI decreased 1.8% y/y, worse than 1.4% expectation and 0.8% previous month, while the country’s CPI increased to 0.6% y/y from 0.5%, missing the 0.7% median consensus prediction surveyed. In contrast to producer prices, which have been declining for 23 months, consumer price growth has been almost negative for about 16 months, significantly below China’s 3% y/y objective. Excluding volatile food and energy costs, the core CPI increased 0.3% year over year. Consumer price inflation increased by 0.4% m/m last month, according to data released by the National Bureau of Statistics on Monday, above the consensus estimate of a flat 0.5%. Next key resistance for USD/CNY remains 7.10 key handle to watch. Key domestic data releases, such as those on industrial output, unemployment rate, and fixed asset investment, should be watched by traders.
JPY Japan’s GDP revision disappoints: Yen outlook uncertain. The preliminary estimate of 3.1% for Japan’s final Q2 GDP growth was revised down to 2.9% q/q, missing the consensus forecast of 3.2%. Additionally, revisions to capital investment and private consumption were somewhat lower, coming in at 0.8% and 0.9% q/q, respectively. Governor of the Bank of Japan, Ueda, has said that more rate hikes might occur if prices and the economy meet the central bank’s forecasts. This modification could indicate that additional patience is required, even though the facts are retroactive. After rallying from the August low of 141.684 and the wide group of important longer-term support levels around 140, the USD/JPY pair generates a short-term momentum divergence buy signal. The national core CPI, exports, and the BoJ rate decision are important domestic data points to monitor.
CAD Downside limited ahead of Fed. With a light domestic calendar, USD/CAD movements this week have been largely driven by developments in the US dollar. Positive factors for the Canadian dollar, such as the outcome of the US presidential debate, have been balanced by hotter-than-expected US inflation data (core CPI and PPI) and a speech from the BoC Governor Macklem, who warned of deeper BoC rate cuts if the Canadian economy continues underperforming. As a result, the pair remains range-bound, trading in the upper half of C$1.35, around 1% above its six-month peak. Short-term realised volatility has dropped to a 10-day low, making it the lowest among G10 currencies. The upside for USD/CAD appears limited, given the growing bets for aggressive policy easing by the Fed, which has triggered broad-based USD weakness. Markets are now pricing in a 45% probability that the US central bank will lower interest rates by 50bps at its meeting on September 18.
AUD Aussie confidence slips: AUD/USD faces headwinds. Australia’s Westpac consumer confidence index for September was 84.6, down from 85.0 in August. In contrast to August’s 2.8% m/m, the mood index was -0.5% m/m. The statistics about the expectations of family finances for the next year increased by 0.2% to 97.0, indicating that the majority of consumers anticipate a significant resolution to the cost-of-living problem by the same time next year. Consumers are becoming increasingly worried about the state of the economy and employment prospects even while cost of living pressures are lessening. Below the 0.68–0.69 resistance zone, the AUD/USD pair clearly reversals bearishly. This week’s economic schedule includes NAB business confidence.
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