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European Macro

• The euro area economy is in reasonable shape but the recovery is likely to be a steady one. Consumer conditions continue to improve but it’s hard to make a case for a protracted period of buoyant growth given persistent policy uncertainty, longer-term structural impediments for the industrial sector and the likelihood of fiscal consolidation ahead. While the ECB has started the ball rolling on rate cuts, the overall monetary policy setting is also likely to remain restrictive for some time. Against that backdrop we see growth at 1.4% next year, close to potential.

• After an extended period of stagnation, the UK economy has clearly started the year on a firm footing and is set for another healthy Q2 growth figure. We expect a slight slowdown in H2 but remain upbeat on the broader UK outlook. As well as improving real income conditions, the return to political stability following this month’s decisive election result is positive after the turbulence of the Brexit years. On monetary policy, BoE officials remain notably divided over the persistence of inflationary pressures which has increased doubts around the timing of the first rate cut.

US Fixed Income: Election scenarios now in focus

Macro View: While the economy continues to make progress on the inflation side of the Fed’s dual mandate, the labor market has softened further and underlying cracks continue to widen. Rates remain a major burden on many groups, including low to middle income households, small businesses, CRE, banks, leveraged corporates, and the government. We continue to believe soft landings are rare and just wishful thinking at this stage. It’s typical that the last piece of the macro puzzle to worsen is the jobs data. The longer the Fed takes to acknowledge it, they run the risk of a deep downturn.

On the jobs front, the June jobs report showed that the internals of the jobs market continue to get weaker. While the headline NFP number came in at 206K, the May and April readings were revised down by a combined 111K. These constant revisions are a red flag that a.) the US jobs market isn’t as robust as initially suggested and b.) that there might be some flaws in the data as measured and how the B/D model adjusts. The household report, which has tended to reflect more weakness than the establishment survey, showed only 116K jobs gained, driven by part time rather than full time employment gains, another sign of underlying weakness. In addition, the unemployment rate ticked up to 4.1% (now officially above the Fed’s 2024 target).

On the inflation front, the picture is looking more encouraging, as June CPI came in broadly below expectations. Headline CPI declined 0.1% m/m (i.e. minor deflation in total prices) from May to June, and the core measure was up just 0.1%, driven by falling housing prices (notable change as it now may be finally catching up to lower market rental costs which have been sluggish), transportation, and energy. Supercore notched a negative reading for the second month in a row. Overall, headline and core CPI have receded to 3.0% and 3.3% y/y. If prices are to continue decelerating at this type of pace, reaching the Fed’s 2% target sometime this year appears achievable. And if we measure US inflation using the HICP method, its already below the 2% level.

Fed view: Given that the balance of risks between jobs and inflation data are getting more evenly distributed, from a pure macro perspective, we continue to view September as the start to the Fed’s easing cycle. In our view, a further delay in rates normalization isn’t warranted because the longer they wait, they may have to cut more aggressively in the future (esp. if macro and/or financial conditions deteriorate further).

FX Outlook

The US dollar has weakened since the last release of the Global Markets Monthly (25th June) driven both by the scaling back of political risks in France and building up of Fed rate cut expectations. The release of the much weaker US CPI report for June provided the most compelling evidence yet that inflation continues to slow. It should encourage the Fed to display more confidence in meeting their inflation target at the upcoming FOMC meeting on 31st July. Another soft US inflation print in the month ahead would set the Fed up to provide a greenlight to begin rate cuts in September. The developments support our view for the Fed to be more active in cutting rates, and for the USD to weaken further in 2H of this year. Former President Trump has become the clear favourite to win the US election later this year. He recently expressed his concern that the USD is too strong, and would welcome a further sell-off. The ongoing decline in US yields, Trump’s specific concern over the high level of USD/JPY and our expectations for the BoJ to tighten policy further at their upcoming policy meeting on 31st July have seen short-term fundamentals turn in favour of the JPY.

USD/JPY - Bearish Bias - 151.00-161.00

EUR/USD - Bullish Bias- 1.0500-1.1100

USD/CNY - Neutral Bias- 7.2200–7.3200

KEY RISK FACTORS IN THE MONTH AHEAD

• The main upside risk for USD/JPY would be if the BoJ again disappoints expectations by outlining plans for only gradual policy tightening in the month ahead. A smaller or no rate hike combined with a slow pace of slowdown for JGB purchases to say JPY5 trillion/month or above would likely trigger a quick reversal of recent JPY weakness. Upside risks would be reinforced further if US inflation picks up in July and the Fed does not signal that they are planning to cut rates in September.
• The main upside risks for EUR/USD can be divided into domestic and external risks. On the domestic front, the EUR could weaken if the euro-zone economy continues to slow in Q3 and political risks in France re-emerge. On the external side, the USD could prove stronger if US inflation picks up in July and the Fed does not signal that it is planning to cut rates in September. Any comments from Trump threatening to impose higher tariffs on Europe on the campaign trail could weigh more on the EUR as well alongside the further evidence of slowing growth momentum in China.
• For USD/CNY, we see both upside and downside risks for the CNY. Further upside can be a concrete policy stimulus package from July’s politburo meeting in addressing cyclical challenges and ministries rolling out specific approaches in echoing reforms mentioned in third plenum. Downside risks could come from a widening yield differential with the US if the US keeps rates higher for longer, further frictions between United States and China (e.g., Biden’s administration currently considering a more severe trade restriction on China on access to advanced semiconductor technology)

European Credit

After the short lived June spread widening credit markets recovered well and credit spreads are now back to close to 2 year tights in IG. The overall EUR corporate IG index has rallied relentlessly in the past months and is now at OAS+110bp, down from z165bp in October 2023 and z146bp in early January 2024.  Overall credit yields have come in  since the ECB started rate cuts yet albeit their timing and speed is still uncertain. The credit markets have tightened from the June wides, induced by the electoral induced sovereign spread volatility.

The benign economic backdrop also remains very supportive for IG credit. The recent oil prices have been in the middle of a band at around USD78 and other risk indicators such as Bund-BTP spread has now rallied back to 128bp, from the June wide of 158bp, and is now close to the 2 year tights of 129bp,from 205bp wides in October 23.

We maintain our view that IG credit continues to be an attractive area for investors, given the mixture of strong underlying fundamentals of the bulk of the members of the index and overall still attractive yield levels, albeit less than in 2023. We expect credit spreads to remain resilient on the back of strong technical demand at current attractive yields. IG credit looks like an attractive market for carry at this point, with some potential for even further spread tightening, albeit in a generally more lateral way.

The geopolitical situation remains unchanged and is complicated with the conflicts in Ukraine and Gaza as well as the security in the Red Sea and potential volatility in tensions in Taiwan. Despite no signs of appeasement these remain a cause of uncertainty, albeit the market has grown used to it. China’s domestic economic uncertainties, add to the overall volatility in risk sentiment. But also here overall sentiment has remained stable. European and UK elections have taken some uncertainty off the table and also the French political picture seems to be under control for now, despite the election results creating a much less stable picture there.

Nevertheless,  cash spreads have rallied significantly but also synthetic indices are not showing signs of respite. Since early January the XO tightened almost 64bps to 289bps and is back at the May tights. Pre-invasion of Ukraine XO was in the 320 area. Main is  also close to the tights 14bps tighter at 52bps since the start of January (October wides of 90bps).