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Market Briefing: Risk Sentiment Worsens After Rollercoaster Inflation Reaction

Data released yesterday showed core inflation hitting a four-decade high, bolstering the case for more aggressive action from the Federal Reserve. Odds on back-to-back three-quarter-point hikes at the November and December meetings jumped, and terminal rate expectations climbed close to 5.25 percent – well above the 4.6 percent forecast provided by central bankers in September.

The initial reaction in equity and foreign exchange markets aligned with tighter policy expectations. Major indices tumbled and the dollar rose. But a profound reversal began by mid-morning, with stock markets and risk-sensitive currencies whipping upward, sending the S&P 500 to a 2.6-percent daily gain.

We can’t explain the reversal. We’d like to suggest that Team Transitory is winning, with energy and durable goods inflation beginning to ease, and foreshadowing a later decline in core prices. But pricing in fixed income markets remains consistent with a front-loaded tightening cycle that tips the economy into a slowdown, and longer term rates remain relatively stable.

The British pound is now trading above the levels that prevailed when Kwasi Kwarteng unveiled his mini-budget on September 23. The Bank of England’s intervention efforts are helping, but reports of an imminent reversal in the government’s position—potentially involving an unwind in proposed tax cuts, and a firing of the chancellor himself—are bolstering sentiment more broadly. Prime Minister Liz Truss is scheduled to brief the press later today.

Wider yield differentials are taking a toll on the euro, pulling it to the bottom of its recent trading range against the dollar, even as the outlook for energy supplies brightens. Germany’s energy regulator reported the country’s storage facilities were now 95 percent full on average, ahead of a self-imposed deadline. A cold winter could still result in painful rationing, but the risk has been materially reduced in recent months.

The loonie is losing altitude as oil prices slump and risk appetites revert to pre-inflation release levels. The currency looks oversold on a near-term basis, but the economy remains extraordinarily vulnerable to a tightening in global financial conditions.

The yen is trading near levels last seen in 1990 after failing to consolidate gains in yesterday’s session. Rumours of a modest intervention effort swirled overnight, but Finance Minister Shunichi Suzuki refused to confirm any action, telling reporters on the sidelines of the G20 meetings in Washington, “We’re watching the foreign exchange markets with a high sense of urgency, and we’ll take appropriate responses against excessive moves”.

US retail sales, due at 8:30, are seen rising 0.3 percent in September. Spending on durable goods has remained remarkably robust, even as services consumption grows.

Economists expect import prices to drop 1.3 percent as falling energy and shipping prices feed through.

The University of Michigan consumer sentiment index is likely to improve further, climbing to 59 in early October from 58.6 in September.

Next week’s clear and present event risks are focused on the UK’s political machinations, China’s 20th National Party Congress, and euro-area inflation data.

Karl Schamotta, Chief Market Strategist

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