The resilience of the US economy continues to confound expectations. It is weathering well the rate increases so far, and optimism has grown further now both the banking crisis and the debt ceiling impasse are receding. The incipient signs of labour market easing have not panned out, and income, spending and (unfortunately) price pressures continue to surprise to the upside. Markets are starting to price in another rate hike from the Fed in the summer and the US dollar is rallying against nearly all its major peers as a result. The one exception continues to be major Latin American currencies, the shining stars so far in 2023, with the Mexican and Colombian pesos topping the rankings last week once again. The data calendar this week is dominated by two events: the flash inflation report for May out of the Eurozone (Thursday), and the May employment report out of the US (Friday). The headline print for Eurozone inflation is expected to pull back on lower energy prices, but the core subindex should remain stubbornly high; it is the latter that the ECB is rightly focused on. As to US payrolls, early hints of a looser labour market have not been confirmed by the latest data, so we may well get another strong print that seals in an additional Fed hike this summer.
Last week’s CPI report provided a nasty shock to the Bank of England. Both the headline and the core subindex came in over half a point higher than expected, with the latter rising to a fresh record high for this cycle. Meanwhile, the May PMIs all surprised to the downside, led by another contraction in manufacturing, although the composite index remains comfortably above the level of 50 signifying expansion. It is clear that more interest rate hikes are coming. Markets are now pricing in more than four additional interest rate increases, and we do not rule out the possibility that the terminal rate will land above 6%. Our bullish view of sterling rests on this prospect, as well as the resiliency of UK domestic demand. Most signs point to only relatively modest growth in the UK this year, though this is far better than previously anticipated, and growth forecasts continue to be revised higher. This includes the IMF, which now no longer expects a UK recession in 2023.
Macroeconomic data in the Eurozone has experienced a certain loss of momentum in the last few weeks. In addition to the poor manufacturing PMI data, first-quarter GDP out of Germany also disappointed, confirming that Germany is in recession, albeit a shallow, technical one. Following the aforementioned upward revision to its UK forecast, the IMF now expects Germany’s economy to be the slowest growing in the G7 this year (-0.1%). We think the German data has been negatively affected by one-offs, including the end of COVID-era state support. That said, it will be difficult for the euro to rally out of the recent trading range against the dollar unless and until market expectation for ECB policy catches up with the reality of core inflation data that refuses to show significant easing. The May flash inflation print will be key in guiding these expectations, as will a scheduled speech from ECB President Lagarde and the accounts from the latest Governing Council meeting, all on Thursday.
The debt ceiling “crisis” appears close to a resolution – an agreement has been reached, albeit this still needs to be voted on by the US government. The agreement provides little in the way of fiscal tightening, which means that the job of fighting inflation will be left to the Federal Reserve. In this respect, the PCE inflation report last week must have made disheartening reading for the Fed. Not only is core inflation stabilising at a far above target level of 5% or so, but nominal incomes and spending are also growing at levels consistent with that level of inflation. Markets have now removed almost all expectations of cuts in 2023 and are also starting to price in an additional hike sometime this summer, at either the June or July meetings. This shift accounts for most of the dollar rally over the past few weeks, which is trading higher against all of its G10 peer’s month-to-date.