Fragile risk and growth concerns limiting USD selling

USD: Sintra message stays the same as growth concerns pick up

The financial markets generally appear to be disassociated from each other at present with FX trading back-and-forth within relatively narrow ranges. Equity markets were resilient yesterday while yields fell but the dollar advanced against nearly all G10 currencies. The least surprising developments came from Sintra in Portugal with Fed Chair Powell, President Lagarde and Governor Bailey all arguing from the same hymn sheet that inflation remains dangerously high and hence additional tightening seems likely. In contrast, Governor Ueda continued to argue that inflation was not high enough to warrant a change in policy.  

Governor Bailey argued that rates may have to remain higher for longer given the stickiness of underlying inflation in the UK but the pound underperformed versus most of the rest of G10 reflecting the news that Thames Water in the UK may have to be brought under government control – the value of Thames Water debt has collapsed on the fears that if brought under government control there would have to be losses suffered by investors in the process.

The Thames Water story is still ongoing but this is a clear example of higher rates feeding through and adding to the woes that have been building for some time. A collapse into government hands will inevitably raise speculation of other problems in the water utility sector and in other highly leveraged sectors that will reinforce uncertainties and undermine investor confidence in the ability of the UK to manage higher rates.

We maintain that rate hike expectations in the UK are way overdone and at some juncture there will be a marked drop in market rates to coincide with less monetary tightening being delivered by the BoE.

The near-term performance of the dollar is therefore tied to both Fed monetary policy expectations and global growth performance. The data coming up remain key – PCE inflation, the ISMs and NFP and the CPI data and we still see scope for that data offering the leeway for the Fed to maintain its pause. But if that is the case, the selling of the dollar will be curtailed by falling inflation elsewhere (Australia and Italy yesterday) and by growth uncertainties (China) or signs of higher rates impacting the real economy (UK). We continue to expect that these opposing forces will keep FX rates in ranges but accept stronger US data next week may alter that dynamic and see the US dollar outperform.

LARGEST 2S10S INVERSION IN ONE MONTH HIGHLIGHTS UK GROWTH RISKS

Source: Bloomberg & Macrobond

JPY: BoJ bar for tightening is being lowered

The yen remains at the weakest level versus the dollar since 10^th November last year when USD/JPY was reversing from levels where the Japan authorities had intervened back then to stop yen depreciation and following the first signs of declining inflation pressures in the US. I think most back then (including ourselves) believed the move back then was the start of a sustained turnaround for USD/JPY.

However, that has not been the case. Although we doubt USD/JPY will return to the highs of last year, the stance of the Fed and the BoJ has resulted in this renewed appetite for buying USD/JPY. The BoJ continues to argue for sustained monetary easing and that was on show in Sintra with Governor Ueda out on his own arguing that inflation remained too low and unsustainable. The stance of the BoJ is certainly helping support the Japan equity markets which is helping in turn to support inflation expectations. Last week though saw the first selling of Japan equities by foreign investors after twelve consecutive weeks of buying. The Topix Index did drop last week with a notable 1.4% drop last Friday likely including foreign selling. However, the Topix has rebounded this week and we would still argue that conditions continue to fall into place for a change in the stance of the BoJ.

While Ueda spoke differently to other central bank heads at Sintra yesterday, he did provide the scenario for a change in monetary policy by suggesting that if the BoJ becomes more confident in its current forecast of inflation picking up next year after an expected decelerating in H2 this year, that could be a reason for a change in policy. So the bar for a policy change is lowering – now we merely need the BoJ’s confidence in its own current forecasts to strengthen. Bringing that more to now, we would imagine that confidence would be strengthened if inflation in H2 falls by less than expected.

USD/JPY upside from here remains limited. Not only because of the above but also the clear increased rhetoric from the MoF expressing opposition to continued yen weakness. Vice Finance Minister for International Affairs, Masato Kanda, has been clear in his comments this week and we suspect once in the zone of 145-150, MoF action could take place with the ultimate goal to ensure a break of 150 is avoided.

KEY RELEASES AND EVENTS

Country	BST	Indicator/Event	Period	Consensus	Previous	Mkt Moving
EC	09:00	ECB publishes Economic Bulletin				!
UK	09:30	Mortgage Approvals	May	49.7k	48.7k	!!
UK	09:30	M4 Money Supply Ex-IOFCs 3mth Annualised	May		-1.9%	!
EC	10:00	Consumer Confidence	Jun F		-16.1	!
EC	10:00	Economic Confidence	Jun	95.7	96.5	!
US	11:00	Fed's Bostic speaks				!!
GE	13:00	CPI Harmonised MoM	Jun P	0.4%	-0.2%	!!!
GE	13:00	CPI Harmonised YoY	Jun P	6.8%	6.3%	!!!!
US	13:30	GDP Annualised QoQ	Q1	1.4%	1.3%	!!
US	13:30	GDP Core PCE QoQ	Q1	5.0%	5.0%	!!!
US	13:30	Initial Claims		265k	264k	!!!
US	15:00	Pending Home Sales MoM	May	-0.5%	0.0%	!!
UK	17:30	BoE's Tenreyro speaks				!!

Source: Bloomberg