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Risk assets pause for breath as Fed pushback becomes more likely

Markets are turning more cautious after last week’s “melt-up” in risk assets, with the dollar climbing against its rivals, Treasury yields ticking higher, and equity markets beating a slow retreat.

The British pound is holding near to a ten-month high against the euro and a 14-month peak against the dollar, supported by rising rate expectations. Following strong labour market and wage growth data, the latest inflation print, out tomorrow morning, is expected to show headline price growth easing only slightly in the the month of May, and the core measure is seen holding close to 6.8 percent in year-over-year terms. In response, the Bank of England is widely expected to deliver another quarter-point hike on Thursday, with several committee members voting for a half-point move – helping ratify market forecasts for a cumulative 100 basis points in tightening by year end.

The euro is modestly stronger after several European Central Bank officials expressed diametrically-opposed views on the likelihood that a widely-expected July rate hike would be followed by another in September. Echoing similar comments from her national counterparts, Executive Board member Isabel Schnabel said “We need to remain highly data-dependent and err on the side of doing too much rather than too little,” saying “We thus need to keep raising interest rates until we see convincing evidence that developments in underlying inflation are consistent with a return of headline inflation to our 2-percent medium-term target”. But Chief Economist Philip Lane noted that a “lot of hiking” had already been done, saying “we will see in September, that’s months away in terms of all the data”.

Japan’s yen continues to come under severe selling pressure, trading near a seven-month low against the greenback and a two-decade low against a basket of major trading partner currencies. The Bank of Japan has remained steadfastly committed to its easy-money policies, even as its global counterparts have ratcheted rates higher, and verbal jawboning efforts from officials – including finance minister Shunichi Suzuki and economic minister Yasutoshi Nishimura last night – have not yet reached the stridency that historically preceded outright currency intervention. For now, the currency’s use in “carry trades” – in which speculators borrow in yen and invest in higher-yielding alternatives – is likely surging, helping to contribute to the overall tide of liquidity supporting global asset prices.

The Australian dollar is also weaker after minutes taken during the Reserve Bank’s latest meeting showed that the surprise decision to raise rates was a “finely balanced” one, making future moves less likely. According to a readout published last night, “the recent data suggested that inflation risks has shifted somewhat to the upside,” combining with an “already drawn-out return of inflation to target” to force the board’s hand – but there was no directional guidance on future rate hikes provided, suggesting that a return to the sidelines in months ahead remains a relatively strong possibility.

We think a similar dynamic could play out in the Canadian dollar tomorrow. Retail sales numbers, out at 8:30, are likely to show a softening in underlying consumer demand as higher outlays on gasoline, services, and interest carrying costs cut spending on goods. At 1:30, minutes taken during the Bank of Canada’s June 7 meeting should show some officials expressing profound reservations about pushing rates higher, even as the balance of risks seemingly tilted toward upside pressure on inflation. Recent data has done little to allay our concerns about interest rate sensitivities in an incredibly over-indebted Canadian economy, and we suspect policymakers have similar worries.

The days ahead will be dominated by Fedspeak. Chair Jerome Powell is scheduled to deliver semi-annual congressional testimony before the House Financial Services Committee tomorrow and the Senate Banking Panel on Thursday, and a series of officials – including St. Louis’ Bullard, New York’s Williams, and Vice Chair Barr – will make appearances today, with Chicago’s Goolsbee, Cleveland’s Mester, and Richmond’s Barkin following later in the week.

Officials might sound less confident than investors currently expect. Markets could double down on bets that the central bank will ultimately fail to deliver two additional rate hikes by year end – hikes that were forecast in last week’s “dot plot” summary of economic projections. The dollar could continue its slide, particularly if paired with a decisive shift in Chinese stimulus rhetoric.

But we suspect the risks remain tilted toward a more hawkish “higher for longer” message. Consumer demand is proving extraordinarily resilient, employment conditions are showing no conclusive signs of deterioration, underlying price growth is subsiding too slowly, and financial conditions are still easing from the levels reached in March. If officials stay on-message – and if Powell warns of the potential for multiple hikes to come – the dollar could stage a modest rebound, particularly against the Aussie, Canadian dollar, and pound, and risk-sensitive asset classes might come under renewed selling pressure.

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