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Rebounding producer prices lift the dollar

The dollar is set to end the week on a slightly stronger note after July’s producer price report solidified expectations for a continued hawkish bias from Federal Reserve policymakers – even as other indicators point toward a cooling in inflation pressures. Yields are modestly higher across the front end of the Treasury curve, equities are seeing outflows, and risk-sensitive currencies like the Australian and Canadian dollars – along with the Mexican peso – are inching lower against the greenback.

North America

US producer prices climbed more than expected in July, putting pressure on policymakers to avoid sending the “all clear” signal on inflation. According to the Bureau for Labor Statistics, the producer price index for final demand rose 0.3 percent month-over-month and 0.8 percent year-over-year, as elevated food and oil prices drove goods categories higher and service-sector prices continued to rise. Markets monitor changes in producer prices – a measure of output prices at the factory gate – closely, as they typically tend to front-run moves in wider consumer prices over a period of six to eight months.

 

Yesterday’s July consumer price index print was the second to show prices rising at an annualized pace close to the Fed’s 2-percent target. This was widely expected to translate into a slightly more dovish tone from monetary policy officials in the run-up to the annual central bank conference in Jackson Hole, Wyoming and the September rate-setting meeting.

Price Indices, Annual Change, %, NSA

And the outlook looks less benign: commodity prices have risen sharply in the recent months, with oil, natural gas, and agricultural inputs gaining as demand rises, and extreme weather disrupts production. Labour markets remain extraordinarily tight, with job creation, unemployment claims, and wage gains all pointing to sustained increases in aggregate demand. Jerome Powell’s hoped-for “compelling evidence” of a decline in inflation pressures isn’t here yet, and may not arrive for many months yet – suggesting that the additional rate hike mooted in the central bank’s June “dot plot” summary of economic projections might remain on the table for now.

 

Still ahead today, the University of Michigan will release its preliminary consumer sentiment measure for August, with economists expecting the index to rise to 71.7 from 71.6 in July. Long-term inflation expectations will remain near a 15-year high, but deepening political polarization has rendered survey responses almost meaningless in recent years, and market participants are likely to take the release with a handful of salt.

 

Next week will bring retail sales for July, with markets expecting receipts to climb another 0.2 percent month-over-month, confirming ongoing resilience in underlying consumer demand. A record of the Federal Reserve’s last meeting is likely to show policymakers maintaining a hawkish bias even as incoming data has delivered more evidence of the disinflationary forces rolling across the American economy.

 

Canada’s dollar remains firmly rangebound as a broader aversion to risk offsets higher crude prices – in US and Canadian dollar terms – in driving price action. Tuesday’s consumer price data is expected to show both headline and core inflation measures remaining sticky, with growing evidence of a spending slowdown failing to translate into a decisive drop in price pressures. We think this could keep rate differentials relatively stable for now, but we also remain convinced that economic headwinds will grow stronger by the fourth quarter, forcing a broader downward revision of expectations for the Bank of Canada relative to the Fed.

Western Canada Select, in Canadian dollars

Europe

The British economy expanded by more than expected in the second quarter, lifting the pound and firming bets on tighter policy from the Bank of England. Data released earlier this morning by the Office for National Statistics showed real gross domestic product expanding 0.5 percent in June, well ahead of consensus forecasts, with industrial production, construction, and extra holiday for King Charles’ coronation doing a lot of the heavy lifting in bringing the second quarter to a solid close. This has led to a slight adjustment in rate expectations: policymakers are still believed on track to deliver two rate hikes by early next year, but cuts are now seen coming later in 2024.

Implied change in policy rate expectations, %

Next week’s jobs and inflation data could help clarify the near-term picture further, but the risks are now clearly tilted to the upside, with stronger consumer demand likely to translate into slightly higher prices through the early part of the third quarter. 

 

The euro is trading with a defensive bias as investors keep downgrading growth and rate expectations, but there is some evidence that “peak pessimism” is in the rear-view mirror, with economic surprise indices turning more positive and climbing off their lows in the last two months. We remain skeptical on the euro area’s capacity to outperform the US – except in the early stages of an employment-led downturn – but an early-year overshoot in European Central Bank expectations seems to have corrected itself, and the common currency appears to be gravitating toward the 1.10 mark as a point of reference.

Bloomberg Economic Surprise Indices

Next week will bring the latest German ZEW investor expectations survey, June industrial production numbers, and a second read on July’s inflation data. A report heavy on statistical adjustments and light on evidence of underlying pressure on core prices could pull expectations for the monetary policy path slightly lower.

Asia Pacific

Asian currency markets are seeing relatively subdued moves with Japan on holiday and the Chinese yuan looking ever more state-managed. The People’s Bank of China set the renminbi fix almost 500 pips below trader expectations last night, indicating that authorities aren’t willing to permit a disorderly move lower in the currency – even as a falling yen boosts Japan’s relative trade competitiveness.

 

Tuesday’s raft of Chinese activity reports are likely to show the economy entering a deepening slowdown, with official stimulus efforts doing little to lift the gloom. Industrial output, fixed investment, and retail sales have all shown signs of softening through the summer, and data released last night showed new yuan loans falling to the lowest levels since 2009 in July, suggesting that demand for credit has weakened further. 

Net monthly change in new loans, billions CNY

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Higher for (even) longer