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Markets see clouds in the US economy’s silver lining

“In the beginning the Universe was created,” said Douglas Adams in the Hitchhikers Guide to the Galaxy. “This has made a lot of people very angry and has been widely regarded as a bad move”. Markets seem to be taking a similar view on yesterday’s hotter-than-anticipated US retail sales report, with an aversion to risk becoming more pronounced as investors grapple with the prospect of higher long-term rates. The dollar is holding its gains and equity futures are setting up for a weaker open even as two- and ten-year Treasury yields fade from their highs. Risk-sensitive units like the Australian and Canadian dollars remain on the defensive, and concerns about a slow-motion credit crisis in China are weighing on the Asian currency complex.

North America

After yesterday’s July retail sales numbers topped expectations, the Atlanta Federal Reserve updated its nowcasting model to show third quarter gross domestic product growing at a 5.0-percent annualized rate, up from 4.1 percent just a week ago. If sustained, this could push recession calls further into 2024 and support expectations for a renewed hawkish tilt in monetary policy guidance, beginning at the central bank’s gathering in Jackson Hole next week. This backdrop is helping the dollar maintain its “cleanest dirty shirt” credentials, continuing the US exceptionalism theme that has only grown stronger in recent months.

Subcomponent contributions to GDPNow real growth forecasts, %

But we’re not confident current spending levels will be maintained. Real wage gains are helping boost aggregate income, yet pandemic-era excess savings are close to exhaustion, even if more optimistic estimates are used, student loan repayments are set to resume, credit conditions are tightening, and lower-income households are going ever more deeply into debt. We expect economic data surprises to begin turning negative in the autumn months, helping bring expected growth differentials into closer alignment across the major developed economies.

Minutes taken during the Federal Open Market Committee’s July meeting, due for release this afternoon, should show policymakers turning cautiously optimistic on the strength of the disinflationary impulse spreading across the US economy.
Data available at the time remained fairly ambiguous, with credit conditions beginning to tighten and a single consumer price report pointing to a deceleration in core inflation, but labour markets remained extremely tight and “clear and convincing evidence” of a decline in price pressures hadn’t yet arrived – and arguably still hasn’t. Markets are prepared for a relatively hawkish tone throughout the meeting record.


Headline inflation fell as expected in the UK last month, but core price growth failed to decelerate, adding to yesterday’s superheated wage data in supporting expectations for further rate hikes from the Bank of England.
Overall consumer prices were 6.8 percent higher in July than a year earlier, down from 7.9 percent in the prior month on a slowing in the pace of food and energy cost increases. With food and energy excluded, annual inflation held at the 6.9 percent pace set in the prior month, while services costs accelerated to 7.4 percent from the prior 7.2, suggesting that domestic inflation drivers remain sticky and powerful. In response to the print, investors maintained bets on at least three more rate moves in the next seven months, while the pound climbed relative to the dollar and euro.

Consumer price index, 12-month % change

Asia Pacific

The Chinese yuan continues to push lower after Monday’s surprise rate cut, but traders are signing pre-nuptial agreements with their short positions as they brace for intervention near the 7.30 handle in onshore markets. In the absence of disorderly moves or outsized capital flight, authorities haven’t applied new restrictions on the yuan in forward markets, buying by state-owned institutions has been modest, and the central bank has avoided selling dollars or taking more overt steps to inject liquidity – but any of these tools could be deployed and two-sided exchange rate risks could emerge if the situation escalates.

USDCNY and USDCNH exchange rates

We note that global liquidity conditions are probably suffering as risk aversion grips Chinese financial markets, with headwinds growing for asset prices in many countries – but we also suspect that concerns about the economic implications of a slowdown are becoming overwrought. Demand for the dollar could surge if financial intermediation flows are disrupted in the event of a hard landing, but after decades of consumer repression, China’s role as a source of final demand for Western exports remains far smaller on a net basis than the headline numbers would suggest, and spectacular growth in the country’s marginal consumption of raw materials faded many years ago.

Japanese Finance Minister Shunichi Suzuki said yesterday that he’s monitoring moves in currency markets with a “sense of urgency,” and avoided using the sort of language that has previously signalled imminent intervention – terms like “one-sided”, “not reflecting fundamentals,” or “excessive”.
An astonishing 6-percent jump in first-quarter gross domestic product isn’t doing much to support the currency – the gain was mostly export-driven, with supply chain improvements playing a big role – but implied volatility levels remain relatively low and there are no signs of a sustained speculative attack on the exchange rate. Continued gradual declines seem likely in the short term.

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