Macro Matters – Weekly review, w/c July 17

Disinflation is now decisively taking hold in the world’s two largest economies. Inflation has been falling in China for several months. There has been some debate about just how stubborn inflation has been in the US. The core PCE (the Fed’s preferred inflation gauge) remains relatively high (around 4.6% currently), but there are now signs that disinflation has grasped the US economy. Year-on-year CPI inflation measures have surprised to the downside for two consecutive months, while at the factory gate, the US PPI also continues to decline decisively. Markets that had been positioning increasingly confidently for two-month Fed rate hikes in 2023 are having to re-adjust quickly. It looks increasingly as though the Fed will hike just one more time, likely at the July FOMC meeting. Although OIS (Fed Funds futures) continues to suggest there is a possibility of a second hike (either September or November), the probability is waning (now around 27% according to CME Group FedWatch). Markets are also looking further out the curve to the timing of when interest rate cuts will resume (now a c. 80% probability of March 2023). This is having a dramatic impact on major markets and risk appetite. It is driving Treasury yields lower, a weaker USD, metals and oil higher, and a rally in equity markets.

A sharp fall in yields and a bull steepener in the yield curve. There has been a massive turnaround in US bond markets. The softer Nonfarm Payrolls report sparked the move but it has been exacerbated by the big downside surprise in the US CPI and then capped off by a miss in the US PPI. Treasury yields have fallen dramatically. The US 10-year yield has dropped from 4.09% to as low as 3.76% (-33 basis points) while the 2-year yield has dropped from 5.12% to a low of 4.61% (-51bps). This sharp move lower in yields is one thing, but the “bull steepening” effect on the yield curve will resonate across asset classes. Primarily, if the steepening continues, it will drive USD weakness. The next key low on the US 10-year yield is at 3.68% (the late June low), while there is downside potential on the US 2-year yield towards 4.32% (early June low and key long-term pivot). The 2s/10s spread has moved from -108bps to -90bps. A further steepening towards the -76/-66 bps area would act as a significant drag on the USD.

United States. Disinflation takes hold while the labor market remains relatively firm. Falling inflation and benign labor market conditions are supporting the US economy. Importantly too, according to the New York Fed, consumer expectations of inflation are reducing. So the risk of persistent inflation taking hold of the US economy is subsiding. However, this is also coming at a time when the labor market has remained firm and unemployment has remained stable at under 4%. The Atlanta Fed’s GDPNow for Q2 remains strong and continues to estimate growth above 2.0%. The banking crisis is in the rearview mirror, while housing indicators are starting to pick up. Consumer Confidence surprised decisively to the upside in June, while the prelim reading of Michigan Sentiment for July has also jumped to a nearly two-year high (driven by strong improvements in both current conditions and expectations). The prospects of a soft landing in the US continue to improve.

The prospects of a less hawkish Fed drive renewed USD weakness. The dollar bulls have had a tough week. The corrective momentum induced by the relatively weak Nonfarm Payrolls report has taken the disinflationary CPI data and turned into a flood of selling pressure on USD positions. Falling yields and a bull steepener on the yield curve have driven the Dollar Index decisively below a key floor of 100.78 (the lows of February and April) to below 100 and levels not seen since April 2022. The USD is strongly underperforming all major currencies over the past month. Hugely significant levels have been broken with decisive moves on several major USD pairs. EUR/USD has pulled clear above 1.1095 resistance, meaning the next important barrier is now 1.14/1.15. GBP/USD has accelerated above 1.31 to 15-month highs. The next important resistance is between 1.3200/1.3350. With Treasury yields falling so fast, it may also not come as a surprise to hear that USD/JPY, a pair so often tied to the fate of yield differentials, has plunged from 144 to 138.50 just a week later.

Earnings season takes hold. US earnings season for Q2 is in its infancy, but its impact is likely to take hold of US index futures over the coming weeks. The big banks have dominated the early newsflow, with a disappointment from Citigroup and the customary strong performance from JP Morgan. Weakness in Citi’s trading business outweighed the positives of personal banking and wealth management. With revenue down by -13%, net profit plummeted by -36%, driving the shares initially down -2%. However, take this in contrast with the performance of JP Morgan which saw a larger-than-forecast increase in Q2 profits. Earnings of $4.37 per share were almost 10% above the average estimate of $4.00. Traders reacted with a rather muted response, with the shares only increasing marginally. JP Morgan is often the leader of the pack in results for the banks, so if this is anything to go by, then caution may begin to set in. According to FactSet, at the beginning of earnings season, quarterly profits for the S&P 500 companies were expected to show a -7.2% decline. As we have the remaining banks and some tech heavyweights this week, the extent of reactions to any positive surprises may begin to become a gauge for traders.

What’s next? The economic calendar has US Retail Sales and Industrial Production, in addition to some regional Fed surveys. Furthermore, earnings season ramps up, dominated this week by the remaining big banks (Bank of America, Morgan Stanley and Goldman Sachs) and a couple of NASDAQ heavy hitters (Netflix and Tesla).

‍