An unsettling updrift in US government bond yields, particularly long-term ones, continued to hobble the performance of both European and emerging market currencies. The market had perhaps become too complacent about the move lower in the dollar after the Fed suggested that it may be done hiking rates. Short dollar positions are stretched, and the year’s popular FX trades (long emerging markets, long the euro, short the dollar) are having a difficult time. Fitch’s downgrade of the US credit rating is being blamed, although we are very sceptical that a single report really added significant information to the most analysed economy and market in the world. The relatively light data calendar this week is dominated by the July CPI inflation report in the US out on Thursday. The spike higher in US yields (with the rest of the world’s rates following suit, as usual) seems to us so far, a technical phenomenon, somewhat disconnected from the good news we have been receiving on US inflation. The July report, and its potential validation of the disinflationary trend in the US, takes on added importance. Thin holiday markets may amplify any market moves after the report is released.
The August meeting of the Bank of England was unhelpful to Sterling. The MPC opted for a small interest rate hike of 25 basis points, in line with our expectations, albeit there were three dissents, with two members favouring a 50bp hike and one voting in favour of no change. The guidance in the statement was unaltered from the previous meeting, hinting that more hikes may be needed should inflation be ‘persistent’. That said, there is now a general consensus that the end to hikes may not be too far away, with the MPC stating that rates are already at ‘restrictive’ levels. As market expectations for the terminal rate recede from the 6% level, the pound is suffering. However, the BoE has also suggested that rates will stay elevated for a long time. Given that the terminal rate is very likely to be the highest among G10 countries, we remain optimistic on sterling, and stick by our bullish forecasts for the pound. This week, the GDP growth report out on Friday will give a lagged read on the health of the UK economy.
The ECB received mixed news from the second-quarter GDP and July flash inflation reports. The former showed that the bloc economy emerged from a technical recession in the three months to the end of June, albeit growth is at anaemic levels. Meanwhile, the latter showed no signs of a disinflation trend, at least in the core subindex, which modestly beat expectations and remains just shy of record highs. The euro remains dependent on European Central Bank policy, which itself is now dependent on future economic data. It is not clear to us how the dichotomy between weak Eurozone activity and stubbornly high core inflation in the Eurozone will be resolved, although we think that the quarterly wage report out of Germany later in the month, followed by the Euro Area data in mid-September, will be unusually important here. Any signs of a further acceleration in earnings could raise concerns over a wage-price spiral, and support bets in favour of additional ECB policy tightening.
The Federal Reserve received mixed news from the July US payrolls report. The headline number was consistent with a gradual loosening in the US labour market, as job creation eased below 200k and missed expectations for the second straight month (following fourteen consecutive upside surprises). On the flip side, unemployment remained near record lows, and unexpectedly dropped back to 3.5%, while wage growth, more importantly, surprised to the upside. Of greater significance to the Fed than last week’s payrolls report will be this Thursday’s inflation numbers. Markets are optimistic that the critical monthly core inflation number will be consistent with the recent disinflationary trend, printing at levels consistent with 2-3% annual inflation. A disappointment on this front could create significant volatility given the fragile technical state the bond market appears to be in.