Softer UK CPI Weighs on Sterling and Lifts Gilts, while Yen Slumps to New Low for the Year, Ahead of the FOMC

Overview: Softer than expected UK CPI has drawn attention ahead of the key event of the day, the FOMC meeting. The UK's CPI has spurred a dramatic rally in Gilts and saw sterling initially extend its recent losses, falling to new four-month lows before stabilizing. The swaps market sees less than a 50% chance of a hike by the Bank of England tomorrow. Meanwhile, even though US Treasury Secretary Yellen suggested conditions in which intervention by Japan would be understandable, the market has little fear of intervention today ahead of the FOMC meeting and took the dollar to new highs for the year above JPY148.00. The greenback is mixed with the dollar-bloc currencies firmer. Among the emerging market currencies, central European currencies and the Mexican peso are among the best performers. 

The large bourses in the Asia Pacific region fell today except South Korea's Kospi. It is the third consecutive losing session for the MSCI Asia Pacific Index. Europe's Stoxx 600 is up about 0.5% after falling nearly 1.2% over the past two sessions. US index futures are trading with a slightly firmer bias. European 10-year yields are mostly 1-2 bp lower. The two standouts today are the UK Gilts, where the 10-year yield is off 10 bp (to ~4.24%) and Greek bonds, where the yield has fallen by eight basis points (to ~4.0%). The 10-year US Treasury yield is a little softer near 4.34% and the two-year yield is off a couple of basis points to 5.07%. Gold is consolidating in about a two-dollar range on either side of $1930. November WTI reversed lower yesterday after reaching almost $92.45. Follow-through selling today has been seen and it slip briefly below $89 before stabilizing.

Asia Pacific

Japan recorded its first monthly trade surplus in two years in June (~JPY39.2 bln) but it was little more than a statistical fluke. It returned to deficit in July (~JPY66.3 bln) and earlier today, Japan reported a JPY930 bln deficit in August. Net exports more than offset the weakness of the domestic economy in Q2 but its contribution looks likely to become a drag this quarter. Exports fell on a year-over-year basis in August (-0.8%). It was the first back-to back decline since late 2020. The decline in imports accelerated. In August, they were nearly 18% lower than a year ago, and in August 2022, they had risen by almost 50% from August 2021, when they were nearly 45% higher over the previous 12 month. This likely reflects higher commodity prices and a weaker yen. Separately, Prime Minister Kishida's recent cabinet shuffle has not generated stronger public support. A poll by Mainichi Shimbun found that the approval rating slipping one percentage point to 25% over the past month. It was the third consecutive decline. The disapproval rating was unchanged at 68%.

Over the weekend, US General Milley, the chair of the Joint Chiefs of Staff said on national television that after a thorough investigation, the intelligence community has concluded with high confidence that the Chinese balloon over US airspace seven months ago was not collecting intelligence. Recall that US Secretary of State Blinken's trip to China was canceled (postponed). The balloon was shot down a on February 4. Milley concluded: I would say it was a spy balloon that we know with a high degree of uncertainty got no intelligence and did not transmit any intelligence back to China.

US Treasury Secretary Yellen indicated that intervention to smooth out volatility could be understandable and Japan's FX boss Kanda said that he was in day-to-day contact with his US counterparts. He warned that excessive moves were undesirable and would not rule out any steps to counter it. Still, ahead of the FOMC meeting outcome, intervention is unlikely, and the dollar has been bid to new highs above JPY148.00. Today is the sixth consecutive session that the dollar has remained above JPY147. One-month implied yen volatility fell to three-month lows yesterday near 8.6%. It is a little firmer today near 8.8%. To boost the chances of successful intervention, as was the case last October, it would help to pick a top to US yields too. US 10-year yield made a new high for the year yesterday (like the dollar) near 4.37%. As was the case before the weekend, the Australian dollar was capped just in front of $0.6475 yesterday. Still, it posted its highest close in two weeks. More formidable resistance is seen in the $0.6500-25. In the bigger picture the Aussie has stopped falling even if it is not making much headway higher. Note that it is higher on the month and has risen in two of the past three weeks. The yen's weakness makes it more difficult for Beijing to manage the yuan's descent. It is not simply because of the mechanism by which the currency is managed and the CFETS basket. For some market segments, the yen and yuan (offshore) share a common characteristic:  extreme policy divergence, low interest rates, attractive candidate for funding currency (for carry trades or other financial structures). Chinese banks kept their loan prime rates steady after not passing through fully last month's cut in the one-year Medium-Term Lending Facility rate. The PBOC set the dollar's reference rate at CNY7.1733. The average estimate in Bloomberg's survey was for CNY7.2958. The gap between the two appears the largest to date. The dollar has held slightly below CNY7.30, but it reached a seven-day high against the offshore yuan near CNH7.3160.

Europe

Construction in the eurozone is not typically a market mover. Yet, amid the string of poor economic news, construction output was firm. Construction rose by 0.8% in July after a 1.0% decline in June. The euro is not only vulnerable to the outcome of today's FOMC meeting but also Friday's preliminary September PMI. The composite has been below the 50 boom/bust level for the past three months and likely remains there in September. 

The UK's August CPI rose by 0.3%, less than half of the median projection in Bloomberg's survey and the year-over-year rate slipped to 6.7% from 6.8%. The core rate fell to 6.2% from 6.9%. The 0.3% increase means that over the past three months, UK CPI has been flat. Meanwhile, producer prices continue to fall on a year-over-year basis. The Bank of England meets tomorrow, and today's data has seen a marked shift in expectations. As of yesterday, the swaps market had discounted an almost 80% chance of a hike. Now, post-CPI, there is less than a 50% of a hike discounted for tomorrow. The market has an almost 90% of a hike between now and the end of the year. Before today's CPI, the market was leaning toward two hikes this year. Some officials have suggested that the pace of QT could be accelerated from the current GBP80 bln a month. With GBP100 bln being the maximum (signaled by the top two BOE officials), GBP90 bln then seems most likely for central-bank think. Ahead of the weekend, the UK reports August retail sales. A bounce back after a 1.2% fall in the headline was reported in July (-1.4% excluding gasoline) is expected. The UK will also see the preliminary September PMI before the weekend. The composite fell below 50 in August (48.6) for the first time since January and likely remained in contracting territory this month.

The euro was turned back from approaching $1.0720 in early North American activity yesterday and was sold back to the session lows (~$1.0675) and closed poorly. The nine-week slide is longer than most traders have seen in their careers, and many are tempted to pick a bottom, maybe like seeing nine reds in a row at a roulette table. The price action, though, is not encouraging. The nine-week losing streak could become ten. Positioning in the futures market does not seem consistent yet with kind of capitulation often seen at the end of a such a persistent trend. The euro has been mostly confined to the quarter-cent range mostly below $1.07, so far today. Sterling bears have been stymied for the past three sessions near $1.2370. The soft CPI figures saw it give way, and sterling fell slightly below $1.2335 before recovering back to $1.2375. There is scope for additional albeit modest gains. Despite intraday penetration, it has not managed to close above $1.2400 either. It has also settled the past four sessions below the 200-day moving average (~$1.2435), the most this year.

America

What officials do is often more important than what they say, but this is not true for today's FOMC meeting. Even some of the more hawkish members have signaled the willingness to pause again after hiking rates at the last meeting. Ironically, despite past efforts to play down the significance of the summary of economic projections, the dot plot, it is the key today. The UAW strike, which may widen at the end of the week, unless there is more progress, and the threat of a partial government shutdown at the start of next month, are difficult to incorporate forecasts. These "known unknowns" may reduce the confidence that members have in their forecasts. If there is a consensus, it is for a hawkish hold by the Fed today. That hawkish element will be expressed through the updated macroeconomic forecasts. In broad strokes, new forecasts will likely anticipate stronger growth this year (perhaps has high as 2% from 1.0% in June). The median unemployment forecast may be shaved to 4.0% from 4.1%. It was at 3.8% in August. In June, the median forecast by Fed officials was for the headline PCE deflator to be at 3.2% at the end of the year with the core at 3.9%. It is possible that the new forecasts raise the headline rate but shave the core forecast. The hawkish hold will also be expressed by maintaining the possibility of a hike in Q4 while reducing the number of cuts anticipated next year from four to three. Lastly, we note that the market has often reacted to the FOMC statement one way and reversed it as Chair Powell's press conference got under way. 

Canada's August CPI was stronger than expected, and this encouraged the market to move in the direction it was moving boosting the odds of a Bank of Canada rate hike in Q4 and taking the Loonie higher. Headline inflation rose twice the 0.2% increase expected by the median forecast in Bloomberg's survey, and this lifted the year-over-year rate to 4.0% from 3.3%. It is the second consecutive increase in the 12-month rate and is the highest in four months. The underlying core measures (trimmed and median) also rose more than expected. Bank of Canada Governor Macklem has referred to the three-month moving average of the underlying core measures. This metric rose to 4% from 3.75% in July. There will be another CPI report before the central bank meets again on October 25. Gasoline prices rose 4.6% in August and the year-over-year rate turned positive for the first time since January. Shelter prices accelerated to 6% year-over-year from 5.1% in July. Grocery prices fell by 0.4% in August, which translates into a year-over-year rate of 6.9% (8.5% in July). The swaps market is now seeing slightly better than a 50% chance of a hike next month, around twice as much as before the inflation report. The swaps market has around an 85% chance of a hike at the December meeting. A week ago, it was seen as slightly less than a 50% probability. Note that the Canadian auto workers reached a tentative three-year deal with Ford that averts a strike. Details have yet to be disclosed. 

Oil prices are rising, but the Canadian dollar is not really a petro-currency, even though it has appreciated over the past couple of weeks. In fact, the correlation of changes in the exchange rate and WTI over the past 30-sessions is near the lowest since February (~0.18) and the 60-day rolling correlation is around 0.35, around the lowest since April. The 30-day correlation of changes in the exchange rate and the S&P 500 is near 0.45 and the 60-day correlation is a little lower (~0.41). The 30-day correlation between the Dollar Index and the USD-CAD exchange rate is around 0.57 and the 60-day is lower (~0.47). The correlation the changes in the exchange rate and the two-year interest rate differential with the US is near 0.34 for the past 30-sessions and slightly lower for the past 60 sessions (~0.32). 

The combination of a softer US dollar in early North America yesterday and surprisingly firm Canadian CPI saw the greenback tumble to almost CAD1.3380, its lowest level since mid-August before rebounding. It held below CAD1.3450 but rose to CAD1.3465 today before turning back. The US dollar has been pulling back against the Canadian dollar since the September 7 high (~CAD1.3700). In the eight sessions since that peak, the US dollar has risen once. The US dollar approached the (61.8%) retracement of the rally from the mid-July low (~CAD1.3090) that is found near CAD1.3365. A break of that is needed to sustain the momentum. There was no follow-through yesterday after the US dollar posted an outside up day against the peso on Monday. The dollar traded quietly inside Monday's range (~MXN17.03-MXN17.18) and remains at the lower end of the range today. Mexico still has retail sales and the CPI for the first half of September due this week and the central bank meeting next week. The peso may be sidelined a bit too by today's Brazil central bank meeting. It is widely expected to deliver its second 50 bp cut in the Selic rate (to 12.75%). For the past month and a half, the dollar has traded in a range between roughly BRL4.84 and BRL5.00. It tested the lower end of the range this week.

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