Last month, when the Federal
Reserve hiked 75 bp instead of the 50 it had signaled, Chair Powell cited the
unexpectedly strong CPI and elevated University of Michigan consumer inflation
expectations. The
June CPI will be reported on July 13, and the preliminary July University of
Michigan consumer inflation expectations will be reported two days later.
This may have been a
tactical error, though only one Fed official seemed to think so. Kansas City Fed President George, a
hawk, favored 50 bp as the Fed had signaled. While
inflation did accelerate, the core rate fell. Moreover, the Fed targets
the PCE deflator, which is less sensitive to shelter and energy prices. The problem with citing a preliminary report is that the final report may be
different, and indeed, it was. Instead of surging to a new high of 3.3%
from 3.0% as the preliminary estimate of 5-10 year consumer inflation expectations had it, the final reading stood at 3.1%,
matching the January high.
It may never be known
whether a Fed official helped prompt the press story the next day, suggesting a 75 bp hike was likely. Some bank economists had nearly immediately moved in that
direction. The implied yield of the June Fed funds futures contract had a 52 bp
of tightening priced the day before the CPI data. It firmed to 57 bp by
the end of June 10, when the CPI and University of Michigan's surveys were
published. After a good weekend think and the press reports, the market
moved to price in 72 bp of tightening.
The "expeditious"
effort to bring the Fed funds rate to neutral and beyond means that the central
bank will use any opportunity it gets or creates. St. Louis Fed President Bullard was
candid about it. The Fed must ratify what the market does
based on the central bank's guidance. Even though some
pundits will cringe at the notion of any similarity between Powell and Volcker,
it may be recalled that Volcker cited money supply growth to justify what he thought
the Fed needed to do in any event.
The Fed funds futures
suggest the market is giving the Fed another option to hike by 75 bp when it
meets next on July 27, the day before the first estimate of Q2 GDP is released. The market went into the weekend pricing around 95% confidence in a 75 bp hike. While
there are clear signs that the economy is slowing, this is what the Fed is
trying is achieve. So rather than deter it, the slowing confirms that the Fed is on
the right course.
Still, the fact that Powell cited the CPI gives the report added importance. The monthly increase will be 1% or higher for the third time in four months. The median forecast of a 1.1% month-over-month gain would lift the year-over-year rate to 8.8% from 8.6%. That would bolster confidence that the Fed will take another three-quarter step. It could also boost the perceived chances of a 75 bp hike in September. The market has about a 1-in-5 chance instead of 75 instead of 50 bp currently discounted.
Nevertheless, a change is afoot. Despite the talk of a broadening of price increases, the CPI core rate is likely to slow for the third consecutive month. The core rate is important, not because it excludes volatile food and energy prices as some pundits have it, but because, as Powell noted, it is a better predictor of future inflation. That is to say that over time, the headline converges with the core rate, not the other way around. Market-based inflation expectations, measured by the 10-year breakeven, fell to new lows for the year in late June, near 2.3%, and have been consolidating below 2.4% recently. The two-year break even, which had approached 4.5% the day before the FOMC meeting concluded, tumbled to almost 3.05% in early July and finished a little above 3.20% last week.
A one or two-tenths rise in
the 5-10-year inflation forecast in the University of Michigan's survey does
not seem as important as the general trend, and it has been flat though elevated
2.9%-3.1% for nearly a year. Instead, what appears more notable is that the reading of
consumer sentiment, which was revised in the final June reading to 50, is
associated with past recessions. Sentiment is not just a mental state,
but that mental state is shaped by what one experiences directly or
indirectly.
The US also reports retail sales, industrial production, and business inventories. Outside of the headline impact, the data points are essential as economists fine-tune estimates for Q2 GDP. This is particularly important because there is a divergence between two historically reasonably good estimates. The first is the Atlanta Fed's GDP tracker, which sees the economy contracting by 1.2%. The other is the median forecast in the Bloomberg survey. This appears slightly closer to the actual first official estimate than the Atlanta Fed's tracker. The median in the Bloomberg survey is 3.0%, but this may overstate the case. What Bloomberg calls a weighted average is at 1.8%, and the mean is 2.8%. The eight forecasts that have been updated this month have an average forecast of 1.55%. Notably, only one of the 60 forecasts projects an economic contraction in Q2.
On July 15, China will report
monthly June data (retail sales, investment, surveyed jobless rate) and Q2 GDP. Bloomberg
apparently conducts two surveys. The monthly poll had 24 forecasts, and
the median forecast was for a contraction of 1.5% quarter-over-quarter after a
1.3% expansion in Q1. The other survey, whose results are posted on the
economic calendar page, has 10 responses has a median forecast of -2.3%. Perhaps the exact print does not matter.
The takeaway is that the zero-Covid
policy means that the official target of around 5.5% growth this year will not
be met. The
multilaterals (IMF, World Bank, and the OECD) estimate Chinese growth at
4.3%-4.4% this year. The market is less sanguine. That said, the stimulative
efforts and the easing of the lockdowns suggest the possibility of a robust
recovery in H2. Of course, with a relatively less effective vaccine and
less fully vaccinated people (especially 60 and older), there is the risk of
further economic disruptions.
China could reduce interest
rates or cut reserve requirements, but its revealed preferences show a cut
in the medium-term lending facility (set on July 15) is unlikely. It trimmed the rate by 10 bp in
January, which was the first cut since the pandemic moves in early 2020 when it
cut the rate by 30 bp. No change in the medium-term lending facility
means that the loan prime rates, set on July 20, will also be kept
steady.
The UK reports May GDP on
July 13. The
monthly GDP unexpectedly contracted in March and April (-0.1% and -0.3%,
respectively) and was stagnant in February. The economy has not grown
since January, and that was after a 0.2% contraction in December. While we have noted that economists do not expect the US economy to have contracted in
Q2, they are less sanguine about the UK. The median forecast (Bloomberg)
is for a 0.1% contraction. A quarter of 36 projections have not been
updated since mid-May. The average of the last five updates (June 30-July 8wir) estimates that the UK economy shrank by 0.4% in Q2.
Just as the Fed hiked rates
while the GDP was falling in Q1, the market is convinced that the Bank of
England will also look through the possible contraction. A quarter-point hike at the August
4 meeting is a foregone conclusion, and the swaps market leans heavily toward a
50 bp move instead (~83%). UK politics may make for good theater but have not been much of a market factor. In the foreign exchange
market, sterling saw its recent slide against the dollar extended and
two-year lows were recorded (~$1.1875). However, as the cabinet resignations mounted
in the first half of last week, sterling rose against the euro and reached its
best level in nearly three weeks. It regained some footing in the second half of the week against the dollar. The $1.2100 area may offer the first hurdle.
Australia reports June
employment figures early on July 14. The Australian labor market is
robust: record-low unemployment and record-high
participation. It has created an average of almost 61.5k full-time jobs a
month through May this year. In the same period last year, the average
was 45.5k, and in 2019 it was less than 19k. After the 50 bp hike
on July 5, the market leans slightly (~55%) toward another half-point move at
the next meeting on August 2.
While the RBA and the BOE do not meet until next month, the Bank of Canada meets next week. The swaps market has a fully discounted 75 bp hike on July 13. It would lift the target rate to 2.25%. The market favors a 50 bp hike at the following meeting but has about a 1-in-4 chance of another 75 bp move instead. The year-end rate is seen around 3.50%. The treatment of the Canadian dollar as a risk asset (high and reasonably stable correlation in recent months with the S&P 500, ~0.70) remains dominant. However, we note that the two other factors in our informal model, namely commodity (oil as a proxy) and rate differentials (two-year spreads as a proxy), have also increased correlations. The correlation between changes in the exchange rate and the two-year differential is the highest in five months (~0.38). The changes in the exchange rate and WTI prices increased in May and stabilized in June and into July (~0.43).
The Reserve Bank of New Zealand is widely expected to hike its cash target rate by 50 bp on July 13. It will then stand at 2.50%. With three more meetings after it this year, the swaps market has another 140 bp of tightening priced into the curve. According to current pricing, that could prove to be the peak, even though CPI is running near 7%. This year, the New Zealand dollar's 9.4% decline makes it the worst-performing in the dollar bloc. The Australian dollar has fallen almost 5.7%, and the Canadian dollar is off slightly less than 2.5%.
Disclaimer
Reviewed by Marc Chandler
on
July 09, 2022
Rating:
