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Markets Hold Firm After Cautious Fedspeak

Federal Reserve chair Jerome Powell was disappointingly non-committal on the likelihood of a September rate cut in yesterday’s appearance before the Senate Banking Committee, explicitly saying “I’m not going to be sending any signals about the timing of future actions”. The Fed Funds futures curve remained essentially unchanged, with two moves priced in this year, and roughly four expected by June 2025.

Dovish hints were there, though, for those determined to find them. In noting that “elevated inflation is not the only risk we face,” saying that labour costs are “not a source of inflationary pressures now,” and emphasising the central bank’s “operational independence,” Powell may have been preparing the ground for what could be a controversial rate cut in September. Short-term Treasury yields are slipping and equity futures are rising this morning – indicative of a modest improvement in risk appetite.

Tomorrow’s inflation print is seen bringing forward expectations for the first rate cut. Consensus forecasts suggest the Bureau of Labor Statistics will report a further softening in headline consumer price growth, with the all-items index rising 0.1 percent month-over-month, and 3.1 percent year-over-year, while the core measure – with food and energy excluded – climbs 0.2 percent relative to the prior month, up 3.4 percent from a year ago. The core services component is expected to broadly maintain last month’s pace.

We’re a little less confident. Although consumer spending has shown signs of exhaustion in a few recent data releases, the most recent Redbook measures of same-store retail sales appear to show warm weather conditions boosting outlays, suggesting that demand-pull inflation factors haven’t yet lost their oomph. As noted in yesterday’s missive, forecasts also look a little too tightly-distributed for our liking, raising the possibility of violent position adjustments if price growth surprises to the upside.

Most of the majors are caught in tight ranges, with the euro, yen, loonie, and Aussie trading virtually unchanged relative to yesterday’s North American “close” against an extremely-quiet data backdrop.

The British pound is creeping higher ahead of a speech from Bank of England chief economist Huw Pill, followed by an appearance from Monetary Policy Committee member Catherine Mann. Dramatic changes seem unlikely, but if Pill – a relative centrist – downplays inflation risks in his economic outlook, market odds on an August rate cut could firm from the current 65-percent levels, putting downward pressure on the currency. Something similar might play out later in the session if Mann – a confirmed hawk – softens her rhetoric. Markets see policymakers delivering four rate cuts by June next year, essentially matching the quarterly cadence expected from the Federal Reserve – but next week’s consumer price report could play a crucial role in determining when the easing cycle kicks off.

The political risk discount embedded in the pound continues to dissipate. The “volatility premium” – calculated as the difference between three-month implied volatility minus 3-month realised volatility in the euro and the pound against the dollar – has been shrinking for more than a year, and even inverted briefly ahead of the weekend’s French election. Investors see an improving outlook for relations with the European Union, an end to fiscal experimentation, and a return to more stable political leadership translating into a burnishing of the UK’s long-dormant safe-haven credentials, even if the economy itself continues to languish.

China’s yuan is under pressure after new data showed consumer prices flatlining for a fifth month, with weak household demand reflecting falling real estate values and depressed job market. According to the National Bureau of Statistics, the consumer price index rose just 0.2 percent from a year earlier in June, down from 0.3 percent in May. Factory-gate prices, which directly impact producer price indices in most Western countries, slid 0.8 percent from a year early, pointing to continued deflation in manufactured goods costs as China attempts to export its way out of a domestic downturn. The yuan has been pinned to the bottom of its permitted trading range against the dollar since the end of March, depreciating almost-imperceptibly in the face of deeply-negative rate differentials and persistent capital outflows.

The Mexican peso is trading on a substantially stronger footing after inflation jumped by more than expected last month, lowering the odds on imminent rate cuts from the Banxico. Although core inflation slowed to 4.13 percent as forecast, the all-items consumer price index climbed 4.98 percent from a year prior in June, above expectations for a 4.87-percent print, suggesting that the peso’s bout of weakness could be driving prices higher in the real economy. Dovish hints in the minutes from the central bank’s last meeting, due for release later today, seem unlikely to convince traders that policymakers have much room for manoeuvre, with a more cautious approach on the cards for coming meetings as officials adopt a wait-and-see attitude.

Carry trade flows are rebounding as investors capitalise on the 575-basis point difference between Banxico’s policy rate and the lower end of the Fed Funds target range, and the political risk discount applied after Claudia Sheinbaum achieved a “supermajority” in the June election is rapidly fading. Risk reversals – option contracts that provide a hedge against strength or weakness in the peso – show that market demand for protection against a decline in the currency has evaporated since the week after the election as Sheinbaum has worked to articulate a centrist policy platform. We think this dynamic could hold through the summer months, but worry that political risk will rear its ugly head once more in the autumn – this time from the US side of the equation, where Mexico’s role in helping Chinese companies sidestep American sanctions could see the country become a talking point in the presidential campaign.

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