Markets Remain on Edge

Overview: The firmer than expected US CPI set off a major reversal of the recent price action. It is a two-prong issue. The first is about inflation and the squeeze on the cost-of-living. The second, and more powerful in the capital markets is how the Fed is likely to respond. This drove US stocks and bonds lower and lifted the dollar broadly. Asia Pacific bourses were a sea of red. Most major markets were off 1-2%, while the Nikkei, the Hang Seng, and Australia’s benchmark off closer to 2.5%. Europe Stoxx 600 gapped lower and is trying to recover though a small gap remains. US index futures are trading firmer, though given the magnitude of yesterday’s losses the small gains seem fragile. Benchmark 10-year yields are firmer. The US 10-year Treasury is up three basis points to almost 3.44%. European yields are mostly 1-2 bp higher, although UK Gilts are steady. The dollar is seeing yesterday gains pared. Reports that the BOJ “checked prices” helped spur the short-covering yen, which is leading the majors higher. Emerging market currencies are mixed, but the Mexican peso’s 0.5% recovery today puts its atop of the EM FX leader board. Gold peaked on Monday near $1735 and slipped below $1700 yesterday. It is steady today, straddling that $1700 level. December WTI is flat after snapping a three-day advance yesterday with a 0.7% decline. US natgas is edging higher and extending its advance for the fifth consecutive session. Europe’s natgas benchmark jumped 6.7% yesterday after falling a little more than 7% on Monday. It is up another 2.5% today. Iron ore fell 2.7% to new lows for the week back near $100. December copper reversed yesterday’s early gains and closed 1.5% lower. It is off a little more today but is finding support about $350. December wheat is edging higher after a small gain yesterday.  

Asia Pacific

Reports that the BOJ checked prices drove the dollar from almost JPY145 to a little below JPY143.00. It is probably best understood as another step in the verbal intervention rather than a signal of material intervention. The sharp rise in US Treasury yields following the stronger than expected US CPI was the fundamental driver. In terms of actual policy, the BOJ announced it would buy more bonds, which is the opposite of tightening financial conditions. The divergence of monetary policy is increasing. The BOJ will buy JPY550 bln (~$3.8 bln) of 5–10-year bonds up from JPY500 bln this month in its regular operations. This is separate from its pledge to cap 10-year yield at 0.25%. The 10-year JGB yields firmed to 0.245%. To be sure, there are still many tactics that can be used. For example, in its intervention heyday, the BOJ is believed to have left orders for banks on an all or none basis, with signal that it did not want to be filled. For example, the BOJ could offer to buy JPY1 bln at a limit price and would only take the fill if it were complete. The bank would not complete the order and ideally be handed a windfall profit as the buying of yen would spur a short-covering rally.

First thing tomorrow, Australia reports August jobs data. It is expected to recover from the weakness in July when it lost nearly 87k full-time positions. The median forecast in Bloomberg's survey is for a 35.0k increase in overall jobs in August after shedding almost 41k in July. More people are expected to have entered the labor market and this could see the participation increase and may see a tick up in the unemployment rate to 3.5% from 3.4%. The Reserve Bank of Australia meets on October 4. After four half-point increases, the market sees a slowing of the pace of tightening. The futures market is pricing in about a 75% chance that it lifts the cash rate target by 25 bp rather than 50 bp.

It is a bit of a cat-and-mouse game between Japanese officials and the market. While the JPY145 level held again, the dollar needs to be pushed below the JPY141.50 area to signal anything important. Intervention risks, as they may be, decline outside of Japan's time zone. With the intraday momentum indicators oversold, the dollar is likely to stabilize and firm in North America today. Initial resistance may be around JPY143.60. The Australian dollar posted a large outside down day yesterday by trading on both sides of Monday's range and then settling below Monday's low. Follow-through selling today found support near last week's low around $0.6700. It recovered and is set to challenge a band of resistance in the $0.6750-70 area. The greenback gapped higher against the Chinese yuan, which largely reflects the dollar's gains seen in the US afternoon yesterday. After settling slightly above CNY6.93 yesterday near its high, the dollar opened today near CNY6.9680 and rose to around CNY6.9730. Last week's high was closer to CNY6.98. There was another large gap between the reference rate (CNY6.9116) and the median projection in Bloomberg's survey (CNY6.9714). The PBOC will set the one-year medium-term lending facility tomorrow. After last month's cut, there was little chance of another cut this month, and the yuan's decline reinforces expectations to a steady rate of 2.75%.

Europe

UK August headline inflation was a touch softer than expected. The 0.5% increase on the month translates into a 9.9% year-over-year rate, down from 10.1% in July, and just below the 10.0% median forecast in Bloomberg's survey. Like we saw in yesterday's US inflation report, lower energy prices were the main driver. The Bank of England had warned that inflation would reach 13% but this was before the new government's plan to cap energy prices for households (18 months) after about a 25% increase next month. This means that many economists will look for a peak in CPI in October closer to 10.5%. Producer prices were also softer than expected. Input and output prices eased together for the first time since 2020. Output prices slipped by 0.1% (to 16.1% year-over-year from 17.1% in July). input prices fell by 1.2% (to 20.5% year-over-year from 22.6%). The median forecast was for a 0.9% rise in output prices and a 0.2% increase in input prices. The BOE meets on September 22. The swaps market is discounting a little more than a 68% chance of a 75 bp hike instead of 50 bp. This is unchanged from the end of last week.

The OPEC report reiterated the claim first aired last month that the markets are wrong. It argues that demand is strong and forecasts global growth this year and next at 3.1%. OPEC left its supply/demand forecasts unchanged from August. The market seems more concerned about demand. Forecasts for China's growth this year was shaved to 4.2% by OPEC but the market may be one percentage point lower. The International Energy Agency, based in Paris, issued its report today. It sees a sharper drop in Chinese demand and projects slightly lower overall demand than it did previously. The IEA recognized that the high price of natural gas has sparked a shift back to crude, which helps underpin demand.

Separately, EC President von der Leyen will deliver the State of the Union speech to the European Parliament and the focus is on the new energy initiatives. Press reports suggest she will call for a 5% cut in consumption of natural gas, a windfall tax, and a liquidity provision to help with margin calls. The strength of the US labor market coupled with higher core prices will means that financial conditions need to tighten further, which will translate into weaker demand. Note that the API reportedly estimated a 6 mln barrel build in US oil stocks, which, if confirmed by the EIA later today, would be the biggest two-week build since early last year. Note that the US reported its biggest drawdown of its Strategic Petroleum Reserves last week (~8.4 mln barrels). The US sales out of the SPR is over at the end of this month. Talk of rebuilding them at $80 a barrel would seem to put a potential floor near there. Still, the net speculative position in the WTI futures market is long nearly 215k futures contracts (100k barrels per). The gross longs have been trending lower since last summer when they reached around 670k. They have fallen every week here in Q3 but one. The gross shorts have been chopped around this year between around 90k and 130k contracts. It was at 111.5k contracts as of September 6, the most recent data. It has grown four of the past five weeks, the cumulative change was about 3k contracts.

The euro extended yesterday's sell-off by 10-15 ticks to almost $0.9955 before finding new bids. There are options for around 650 mln euros that expire today at $0.9950. In early European turnover the euro poked above parity but ran into offers near $1.0010. There is scope for more short covering in North America but will likely be capped in front of $1.0050. Sterling posted an outside down day yesterday, reversing from almost $1.1740 to trade a little below $1.15. It marginally extended the losses to $1.1480 before stabilizing to test the $1.1550 area in European dealings. Scope for additional gains may be limited to the $1.1575-85.

America

The US CPI again surprised on the upside. The market is again flirting with the idea that the Fed could hike by 100 bp next week instead of 75 bp. It moved above a 50% chance intraday but settled yesterday at about 32%. Importantly, the market now sees the terminal rate at least 4.25%. That is on the basis on headline CPI rising by 0.1% instead of falling by 0.1%, as the median in Bloomberg's survey had it. The core rate rose twice as much as expected, and the 0.6% increase lifted the year-over-year rate to 6.3% from 5.9%. However, the more aggressive the Fed is now, the more convinced the market is that it will break something, making the proverbial soft-landing even more elusive. 

Specifically, the implied yield of the December 2023 Fed funds futures contract is 47 bp below the implied yield of the March 2023 contract. That is the most in over a month. There will be more insight from today's producer price report that will help economists fine-tune forecasts for the PCE and core deflators (September 30). It looks as if the headline ticked lower and could approach the low for the year set in January at 6.0%. The core deflator may rise toward 5.0% from 4.6%.

Concerns in the Treasury market after soft results to the three- and 10-year auctions this week seem to be put to rest with the strong demand for the $18 bln re-opening of the 30-year bond. Indirect participants took 72.6% of the issue. Rarely has it been higher, leaving primary dealers with a lowly share of less than 11%. The lighter inventory suggests less pressure to mark it down to move it.

Even if the freight strike does not take place, the disruption is already taking place. Reports suggest that some railroads have halted grain shipments, and some have stopped taking hazardous materials, including ammonia fertilizer. The key issue for the last two unions is about unpaid leave. The Biden administration is pressing for an agreement, and in the last-minute Congress could act. A full national strike, the first of its kind in 30 years, would be worsen the challenges of supply chains and inflation.

The US dollar posted an outside up day against the Canadian dollar yesterday and extended the gains to almost CAD1.32 before stabilizing. The CAD1.32 level has been penetrated on an intraday basis three times in the past couple of months but has not closed above it once. The greenback is consolidating in a narrow range, mostly above CAD1.3150. The key is the broader risk appetite and US stocks. The dollar jumped to nearly MXN20.1060 yesterday, a four-day high. It has come back offered and its trading around MXN19.98 in Europe. There is scope toward MXN19.93, and possibly MXN19.90 if US equities stabilize. 

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