Implied volatility is falling and risk-sensitive currencies are recovering after US House Speaker Nancy Pelosi’s aircraft exited Taiwanese airspace without triggering a military response from China. Commodities are firmer, equity indices are marching higher, and safe haven currencies – the dollar, yen, and Swiss franc – are back on the defensive as traders position ahead of what is expected to be a strong non-farm payrolls report on Friday.
Yields shot upward yesterday, staging the fourth-biggest rally in five years as a series of Federal Reserve officials pushed back against markets’ overly-dovish interpretation of last week’s decision. San Francisco president Mary Daly said the central bank was “nowhere near” done with fighting inflation. Cleveland’s Loretta Mester warned “compelling evidence” of softening prices would be needed before changing course. Chicago’s Charles Evans said a 50 basis-point move at the September meeting might be “reasonable”, “but 75 could also be okay”. And St. Louis’ James Bullard suggested rates would need to stay “higher for longer”.
This was terribly predictable: in raising rates and reversing quantitative easing, policymakers are explicitly trying to tighten financial conditions, not ease them. Last week’s reaction was counter-productive, to say the least.
As yields jumped, there was some chatter about whether China might “weaponize” its holdings of US Treasuries. This is largely nonsensical. Such a move is certainly possible, but if China were to sell its assets and convert the proceeds into a currency other than renminbi, it would suffer losses far out of proportion to the impact on the United States – especially in markets backstopped by the Federal Reserve. And if the proceeds were converted into renminbi, China’s exchange rate would surge upward, harming the country’s export sector. We don’t think any significant market participants traded on this narrative, implying that the move was driven by a change in Fed expectations instead.
The euro, pound, and Canadian dollar are all range-bound, but the yen is falling as yield differentials turn against it once more. Japan’s currency rallied toward the 130 mark against the dollar yesterday, before fading as US rates surged.
Crude prices are softening as the OPEC+ group of oil-exporting countries meets. The cartel is thought likely to authorize a modest increase in production as it heeds US President Biden’s entreaties while also grappling with falling prices, widespread demand destruction, and Russia’s war in Ukraine. But spare capacity is dwindling and many members are struggling to meet export quotas as it is, meaning that any output announcement might be symbolic in nature, and unlikely to have a dramatic impact on prices.
Factory orders are seen rising in June, with consensus estimates showing a 1.2 percent increase from the prior month. The data will be released at 10 am.
Fed speakers could keep up yesterday’s hawkish narrative, with the Philadelphia Fed’s Patrick Harker, Richmond’s Thomas Barkin, and Minneapolis’s Neel Kashkari scheduled for speaking engagements today.
Three of the biggest emerging market central banks are expected to hike rates. The Central Bank of Brazil is set to signal an openness to further adjustments as it raises its benchmark Selic rate by 50 basis points later today. The Reserve Bank of India could raise its repo rate by another 50 points. And traders see the Bank of England delivering a 25- or 50-basis point hike tomorrow morning, raising rates into what is increasingly likely to become a profound economic downturn. All three are trying to fight inflation pressures that are largely imported – and exacerbated by currency weakness.