Good morning. The US dollar is trading near a seven-month low ahead of key inflation data today and tomorrow that could determine the outcome of next week’s Federal Reserve meeting. Flows through the Strait of Hormuz have slowed to a trickle after a series of American and Iranian attacks on ships and energy infrastructure, forcing global oil prices back above $100 a barrel. Ten-year Treasury yields are holding near a three-year high after the Treasury said yesterday it would buy just $6bn of long-dated bonds in its buyback operation, disappointing investors who had expected a purchase volume closer to $10bn. Currency markets, by contrast, remain surprisingly placid, with implied volatility remaining subdued across the major pairs—suggesting investors expect ongoing trade wars to do little economic damage, central banks to keep moving in relative synchrony, and risk assets to stay well supported*.
=The yen is holding firm around a seven-month high after a senior Bank of Japan official argued for further tightening. Board member Kazuyuki Masu flagged a recent 7% jump in producer prices and said a weak yen was feeding through to consumer prices more forcefully than in past cycles, pushing underlying inflation “very close” to 2% target. The central bank may need to raise rates rapidly if price pressures accelerate, he warned, setting the stage for a faster normalisation in Japanese policy and a narrowing in interest rate differentials with the rest of the world. Markets now see a hike at next week’s meeting as nearly certain, with two subsequent moves priced in by next June.
The euro is trading near its strongest levels in two weeks as investors prepare to parse the communications accompanying this morning’s rate hike from the European Central Bank. Today’s move is fully priced in, and expectations for further tightening are elevated, with markets discounting two additional moves by June next year. If officials raise growth and inflation forecasts sufficiently, those assumptions could remain intact—keeping the euro aloft—while a more cautious tone might see rates and the common currency slip. We’re inclined to believe Lagarde & Co. will struggle to out-hawk markets, and think spot market risks are to the downside.
Today’s US producer price update will help calibrate market positioning ahead of tomorrow’s all-important consumer inflation report, with direct consequences for pricing around next week’s Federal Reserve decision. Consensus expectations are for a moderate 0.3% month-over-month increase in core wholesale prices in August, but a number of cross-currents—tariffs, energy prices, medical fees, and rising stock market values—could see upstream costs shifting by more than anticipated. Tomorrow, headline consumer prices are seen rising 3.4% year over year, while the core measure slips to 2.4% from 2.5% previously. Futures markets are putting the probabilities on a hike next Wednesday near 70%, with at least one additional move expected by March. Firm inflation numbers might push those odds close to certainty, while an easing in price pressures could tip a majority of the Fed’s 12 voting officials toward leaving rates unchanged for now.
Tomorrow’s gross domestic product report will matter for the British pound. Economists think the UK economy expanded by 0.2% in the second quarter, slower than the 0.4% recorded in the first three months of the year but better than the Bank of England had anticipated, as households and businesses looked through a series of energy shocks and increased spending and investment. A firmer-than-expected print could bolster the case for further tightening and lend sterling modest support, while a downside surprise might revive concerns about the economy’s ability to absorb higher energy costs, seeing the pound give back some of its recent gains against the dollar.
More broadly, the role that US fiscal concerns are playing in driving yields higher may be overstated. The US government is indeed borrowing more than all of its advanced-economy counterparts combined, and is on an unsustainable path. But among its peers, the US has seen the smallest proportional change** in government bond yields since the Iran war began in late February. This suggests*** that while fiscal worries are real, the primary culprit for the rise in global rates is more likely to be found in the energy price shock that has forced central banks onto a more hawkish footing.
The United States (and Canada) are unusual among the major advanced economies in maintaining a positive gearing to energy prices. The boom in US shale output during the late 2010’s delivered a degree of oil-and-gas independence, so that the country’s commodity terms of trade—the price of its commodity exports relative to its imports—now improve when energy prices rise. That lower sensitivity means the Federal Reserve doesn’t need to tighten by as much as many of its counterparts, and has translated into a relatively-smaller jump in bond yields, with downstream consequences for rate differentials and the dollar’s performance itself.
*A sentence that may be best read while playing a horror-movie soundtrack.
**Note that bond yield changes are typically expressed in basis points, which can obscure the role that starting levels play. In this case, I’ve “rebased” rates back to February 27 to show proportional changes more clearly.
***There are, of course, many variables at work that defy any decisive conclusions.