Political risk premia in Europe have fallen slightly this week as investors continue to gauge how likely the far-left or far right-parties are to gain the absolute majority in this month’s French general election. Implied volatility remains elevated, though.
Lower yields and disinflation have supported US equity benchmarks to record highs. As it stands, the S&P has not experienced a 2% drop in 334 days, the longest streak since 2017-2018.
Evidence of a cooling consumer spending story is mounting after the 0.1% m/m rise in US retail sales missed the 0.3% consensus. April’s figure was also revised to show a 0.2% contraction rather than the 0% outcome initially reported.
The BoE voted 7-2 in favour of keeping rates at 5.25% for another month just a day after the annual inflation rate fell to 2% for the first time in almost three years. While services inflation remains elevated, markets see two rate cuts by the end of 2024.
The Eurozone composite PMI edged down to 50.8, sharply missing the market consensus of 52.5, indicating a softening in the bloc’s private sector conditions. The print marked a fourth month of expansion but was the lowest reading since March.
The options market highlights traders are the most bullish on USD in over a year. Safe haven flows and rising risk premia in Europe remain the best explanatory factors for US dollar resilience, as well as relatively hawkish Fed signals. Inflation prints around the world and European soft data will be key events next week.
Global Macro
Record highs for equities as FX remains pressured
Equities topping records. Lower yields and disinflation have supported US equity benchmarks to record highs. As it stands, the S&P has not experienced a 2% drop in 334 days, the longest streak since 2017-2018. It’s also noteworthy that the S&P 500 has set 31 new all-time highs in 2024 after two years without one. In fact, among the world’s 20 largest stock markets, 14 have soared to records recently, driven by several factors including interest rate cuts, healthy economies and strong corporate earnings. Such a backdrop in equity markets would usually coincide with US dollar weakness, but instead, demand for the world’s reserve currency has sprung back to life after a period of rangebound trading.
Yuan continues to fall. The PBoC also left key lending rates unchanged at the June fixing, aligning with market expectations, whilst the benchmark 1-year loan prime rate was maintained at 3.45%. Meanwhile, the 5-year rate, a reference for property mortgages, was retained at 3.95% following a record cut of 25 basis points in February. Both rates sit at record lows amid the fragile economic recovery that reinforces calls for more support measures from Beijing. One reason for the lack of further stimulus is the stronger US dollar, which continues to challenge Chinese officials. If there is no serious pushback to support the renminbi, traders will push the dollar-yuan exchange rate into a higher range.
Macron survives first test. In an ordinary course of business, bond auctions do not typically attract much attention. However, this round of French bond auctions was the first big test since Macron’s shock announcement of a snap election earlier in the month and was met with solid demand, a sign the political turmoil has yet to deter potential buyers. Bids across all sales were 2.41 times the total amount sold, broadly in line with the previous sales of similar maturities. The bond auction results suggest that the recent selloff has taken yields to levels high enough to entice buyers, indicating for now we have likely reached the peak in the so-called French risk premium.
Regional outlook: US & UK
Inflation at target implies BoE rate cuts
US consumer cooling. We are seeing more evidence of a cooling consumer spending story after the 0.1% m/m rise in US retail sales missed the 0.3% consensus. April’s figure was also revised to show a 0.2% contraction rather than the 0% outcome initially reported. Constraints on spending will likely intensify as well amidst flat real household disposable incomes, high borrowing costs and declining consumer confidence. The recent figures favour an economic backdrop for the Federal Reserve (Fed) to cut interest rates this year, especially with inflation pressures seemingly moderating and unemployment ticking higher.
Inflation at target at last. Although inflation came in at the Bank of England’s (BoE) 2% target for the first time in almost three years, sticky services inflation remains almost twice that of its 2000-2019 average and will likely delay the first interest rate cut by the BoE until August. Services inflation, a series identified by the Monetary Policy Committee (MPC) as being a key indicator of inflation persistence, was much higher than the BoE anticipated last month, ending hopes of an interest rate cut at the BoE’s meeting in June. This month, services inflation has stayed sticky, slowing to 5.7%, above a 5.5% estimate. Another metric closely watched by the BoE is private sector wage growth and that continued to slow in April.
BoE to cut two times this year. The (BoE) voted 7-2 in favour of keeping rates at 5.25% for another month. There were some key takeaways to digest from the BoE’s statement and meeting minutes, which revealed the decision not to cut rates was “finely balanced” as there were divisions among the majority about the importance of surprisingly strong services inflation recently. The message came a day after data showed UK inflation fell to the central bank’s 2% target for the first time in almost three years, though the closely-watched services sector number slowed less than expected. But some policymakers, although voting to keep rates unchanged, signalled upside services inflation surprises have not altered the disinflationary trajectory that the economy was on.
Regional outlook: Eurozone
The bloc continues to struggle in Q2
Flash PMIs take a turn for the worse. The preliminary HCOB Eurozone composite PMI edged down to 50.8, sharply missing the market consensus of 52.5, indicating a softening in the bloc’s private sector conditions. The print marked a fourth consecutive month of expansion but was the lowest reading since March. The weakness mainly stems from the deteriorating conditions in the manufacturing sectors, which fell to a 6-month low. Services sector too showed signs of faltering as the flash PMIs fell to 52.6 in June, a fifth month of growth, although the lowest for three months. At a regional level, France and Germany reported a fall in their composite indices to 48.2 and 50.6 respectively. As for the former, output expectations for the next twelve months have weakened, as companies expressed uncertainty about the upcoming election results, as well as more broad geopolitical risks.
Eurozone investor morale at 2-year high. The German ZEW economic sentiment indicator rose to 47.5 in June, the highest level since February 2022, missing market expectations of 50. Meanwhile, the assessment of the current situation in Germany remains depressed as the current conditions subindex deteriorated to -73.8 from -72.3, missing expectations of -65. The broader Europe-wide expectation index surged to the highest level since July 2021, marking the ninth consecutive improvement in the morale gauge, lifted by hopes that rate cuts by the ECB and lower inflation will offer an improved backdrop for the European economy.
PPI falls the least in 11 months. Producer prices in Germany dropped by 2.2% y/y in May, softer than a 3.3% decline in the prior month. It was the 11th straight month of producer deflation but the lowest figure in the sequence, amid falling energy prices, notably in natural gas and electricity. Monthly, producer prices unexpectedly were flat, compared to a 0.2% rise in April and estimates of a 0.3% growth.
Week ahead
Inflation around the world – It’s complicated
All eyes on US inflation. The narrative of the US disinflation continues to gain credibility among market participants as both the consumer, producer, and import price indices for the month of May surprised to the downside. Incorporating the newest data into a simple regression model on the Fed’s preferred price gauge (core PCE) gives us a monthly growth rate of 0.1%, which would be seen as further progress to reaching the 2% target. This could put the annual headline number on track for a fall from 2.7% to 2.6% in May. Option markets are pricing in two rate cuts from the Fed for 2024 with the first one expected to be delivered in September.
Complicated inflation picture. Inflation in other parts of the world will be important as well to gauge where monetary policy is headed. Disinflation in Canada might allow the central bank to continue the discussion of rate cuts as the headline inflation rate is expected to have fallen from 2.7% to 2.6% in May. The recent string of weaker than expected inflation readings throughout the developed world might reverse in the later parts of 2024. Countries in emerging markets like Poland have already seen their inflation bottom and start to pick up again. Australia’s CPI report might show inflation pick up from 3.6% to 3.7%, strengthening the case for the RBA to remain the last G10 hawk standing.
Recovery stalling? The European recovery appears to have stalled in June with the flash PMIs broadly disappointing expectations and German industrial production weakening as well in May. Investors are not turning their attention to the soft data confidence indicators from the Ifo, GfK and DGECFIN institutes to gauge how the second quarter is going underway. We don’t expect drastic change with the German business and consumer confidence numbers remaining largely unchanged.
FX Views
Dollar supported by global macro
USD Stable despite falling yields. It’s been a relatively calm period in the spot market for the US dollar of late, despite US yields falling to a 2-month low. The dollar came under slight selling pressure as US retail sales rose by less than expected in May, reinforcing the probability (60%) of a Fed rate cut in September. The US 10-year Treasury yield dropped to 4.19%, its lowest level since the end of March, but the US dollar index held firm above its 100-week moving average, which has offered decent support since early May. The options market also highlights traders are the most bullish on USD in over a year. Safe haven flows and rising risk premia in Europe remain the best explanatory factors for US dollar resilience, as well as relatively hawkish Fed signals. We expect recent range-bound trading to extend into June 28, when the Fed’s preferred measure of inflation – the core PCE price data – drops in. The first US presidential debate on June 27 might also ruffle the dollar’s feathers if it sways prediction markets towards a Trump or Biden victory later this year.
EUR Looming French election limits upside. The euro’s performance has been significantly depressed by elevated French election premium and worse than expected flash PMIs. Falling realised volatility translated into EUR/USD spot trading in a largely restricted zone of $1.068-1.075 throughout most of the week with the euro struggling to convincingly bounce back from the 7-week lows. With European macro data playing a secondary role in currency movements, the focus remains on signs of further stabilisation in the French bond market and US-centric developments. EUR technicals point to a possible near-term rebound as EUR/USD currently sits near the lower Bollinger band. However, the looming French election maintains OAT-Bund yield spreads above 76bps, suggesting limited upside. For now, EUR/USD remains capped by the 50-week SMA at $1.0814. In the FX options market, risk reversals with tenures of 3 months and less remain skewed in favour of euro puts against most G10 peers, with the most bearish sentiment observed across USD, JPY and CHF crosses.
GBP Undeterred by BoE cut signal. GBP/USD is over one cent short of its 5-year average of $1.28 but is still trading above its 2024 average of $1.26. GBP/EUR has retreated from recent 22-month highs but remains afloat the €1.18 handle – three cents above its 5-year average. Relatively high yields within the G10 space have helped sterling this year, but another constructive factor could be the improving UK economic outlook. Our soft data proxy for economic expectations has turned positive for the first time in two years, which has a strong positive correlation with GBP/USD. Despite the positive macro backdrop, sterling’s resilience appears somewhat surprising compared to swap differentials, especially since the dovish BoE hold resulted in bets of an August rate cut jumping from 30% to 60% this week. Perhaps this is also because beyond cyclical and monetary policy considerations, the prospect for more stable UK politics and closer UK-EU relations under a potential Labour Party leadership might come as a fresh bullish driver for GBP in the second half of 2024.
CHF Knee-jerk drop after SNB cut. Much hype has surrounded the Swiss franc of late given its safe haven status and the latest Swiss National Bank (SNB) meeting. Hedging against volatile price swings in the Swiss franc on the day before the SNB meeting came at the highest cost since late 2022, whilst the need to hedge against tail risks had been offsetting any carry allure. This explains the over 3% appreciation of the franc versus many G10 peers since the start of June. However, the franc erased a chunk of these gains after the SNB did indeed cut its benchmark rate for the second time this year and lowered its inflation forecasts. We’re cautious about chasing extended CHF weakness in the short-term though as haven-related flows may yet support the Swiss currency heading into elections in France and the UK.
CNY Chinese economic signals: A mixed bag. China’s pivotal economic activity indicators for May portrayed a mixed picture. Retail sales surged by 3.7%, outperforming expectations of 3% and the preceding month’s 2.3% reading, likely buoyed by the Labour Day holiday festivity. However, industrial production growth disappointed at 5.6%, falling short of the anticipated 6.2% and the previous month’s 6.7%, amidst trade frictions and tariff threats. Fixed asset investment expansion decelerated to 4% in the January-May period, missing expectations of a steady 4.2% growth rate, according to data from the National Bureau of Statistics (NBS). The real estate sector remained mired in challenges, with property investment declining by 10.1% in the January-May period. Chart shows the US-China rate differentials correlation may see USD/CNY trading higher. Traders should remain attentive to key domestic data releases, such as Chinese industrial profit figures.
JPY Japanese yen dynamics under scrutiny. The Bank of Japan’s monetary policy meeting minutes from April 25-26 unveiled a nuanced deliberation concerning the weakening yen’s ramifications on inflation trajectories. Certain policymakers acknowledged the potential necessity for policy recalibration if the currency’s depreciation significantly swayed the inflation outlook or posed risks. Moreover, there was a proposition to meticulously modulate daily bond acquisitions in tandem with market supply and demand dynamics. Furthermore, a gradual divestment of ETF holdings was advocated, even if the process proved protracted. USD/JPY crosses the 159 handle on June 21st. Fears of intervention by the BoJ comes to the fore as the pair heads toward the 160 key psychological level. Traders should remain vigilant toward key domestic indicators, including the Tokyo core CPI and industrial production data, for potential market reverberations.
CAD Rangebound trading resumes. The Canadian dollar remains largely rangebound, trading near the bottom of its recent trading range around C$1.37 against the US dollar. Persistently wide interest rate differentials offset upward pressure from oil prices. The 2- and 10-year government bond yield spreads hovered near 80 and 89 basis points respectively, limiting any positive impact from WTI benchmark breaching past the $80 threshold for the first time since the beginning of May. The BoC summary of deliberations has not significantly altered market expectations, Investors anticipate two 25 basis point cuts in July and October. These anticipated rate cuts contribute to the limited strength of the CAD. From a technical analysis perspective, the USD/CAD pair finds support at the 35-day SMA around the $1.3685 level, which may further supress gains for the CAD. Additionally, market sentiment, as reflected in options trading, remains bearish for the Lonnie. The 1-month USD/CAD risk reversal, a measure of the skew in demand for options, favours USD calls (bullish for USD) at 0.37 vol, close to 7-week highs. This indicates that traders are currently more inclined to bet on USD strength over CAD.
AUD Australian inflation dynamics in focus. The Reserve Bank of Australia (RBA) maintained the cash rate at 4.35%, in line with widespread expectations. The central bank’s statement indicated a hawkish shift in language, stating that “inflation remains above target and is proving persistent,” a departure from the previous month’s phrasing of “inflation remains high and is falling more gradually than expected.” The statement acknowledged that the pace of inflation decline had slowed in the most recent data, while data revisions suggested stronger consumption and broader indicators pointed to continued excess demand in the economy. The RBA emphasized its resolute determination to return inflation to target, stating, The statement also highlighted the uncertainty surrounding the optimal interest rate path, leaving all options open. A drop below 0.6539-0.6574 would completely derail the bullish trend momentum associated with the April-May bounce. Traders should closely monitor upcoming monthly CPI indicators, housing credit, and private sector credit data for potential market implications.
