Johnson's Ability To Lead Tories Into Victory At Risk With Today's By-Elections

Asia Pacific equities were mixed. Gains were recorded in China, Hong Kong, Australia, and India, among the large markets, while Japan was mostly flat and South Korea and Taiwan shares fell. Europe's Stoxx 600 was off about 0.7%, the same as yesterday. US futures were slightly firmer.

The rally in bonds continued. After falling nearly a dozen basis points yesterday, the US 10-year yield was off another 5 bp today around 3.10%; it was near two-and-a-half week lows. European yields were down 14-19 bp. The 10-year Italian yield that had poked above 4% earlier this month was near 3.40%. It was the sixth session in the past seven that yields have fallen.

The dollar was trading with a firmer bias except against the yen, where the threat of verbal intervention and falling US rates helped the yen recovery. Despite Norway's larger than expected 50 bp move, the krone and the Swedish krona were the weakest of the G10 currencies. Emerging market currencies were mostly lower, led by central Europe.

Gold was consolidating in a narrow range around $1835. August WTI fell over 3% yesterday and today it was pinned in the lower end of yesterday’s range, but looked poised to recover more in North America.

US natgas was off 2%, but the shock in Europe continues. Its benchmark was up for the ninth consecutive session and today’s 7.5% surge was the most since the middle of last week.

The Singapore iron ore futures we track, jumped nearly 8% today, the most in three months. However, copper was not getting such a reprieve. It was off 2% after a similar decline yesterday. September wheat was also down about 2% today and was at its lowest level since March. 

Asia Pacific

Japan's composite PMI rose for the fourth consecutive month, and at 53.2 it stood just below the cyclical high set last November. It contrasted with most others who have reported a decline in the June flash PMI composite. However, that was arguably not the most important development today as Japan's recovery had already been in tow.

Instead, there were two other developments to note. First, last week, when the BOJ bought around $80bln of bonds, foreign investors sold a record amount (~$35.5 bln) and liquidated almost JPY945 bln Japanese equities. Second, into the fray waded former Ministry of Finance head of fx, Nikao, who raised the specter of unilateral intervention.

This threat marked another step-up in the intervention escalation ladder. Just because he said it was so, didn't make it so, and we hastened to point out that the sometimes failed intervention was worse than no intervention. In an intervention operation, Japan would be isolated, and the action would not signal a change in monetary policy.

Australia's preliminary manufacturing PMI ticked up to 55.8 from 55.7 but was not sufficient to offset the erosion of the service PMI to 52.6 from 53.2. The composite slipped to 52.6 from 52.9. It was the first back-to-back decline since July and August (which was part of a four-month fall). It was the lowest since January.

The market was gradually moving away pricing in a 50 bp hike on July 5. The futures market had a 39 bp increase discounted, down from 56 bp in the middle of last week. Central bank Governor Lowe pushed against a 75 bp hike. It was near a two-week low today.

A combination of lower US yields and the threat of unilateral intervention knocked the greenback down against the yen for a second session. It set a high yesterday near JPY136.70 and had been sold to around JPY135.25 today. A break of JPY135 would likely spur a test on the week's low set Monday near JPY134.55.

The Australian dollar was also pushing lower for the second consecutive session. It was near a six-day low by $0.6865. Last week's low was closer to $0.6850, and last month's low was near $0.6830. The Aussie appeared to be trying to stabilize in the European morning.

The Chinese yuan was trading in a narrow range today, roughly CNY6.70 to CNY6.7150, and remained within yesterday's range. The PBOC set the dollar's reference rate at CNY6.7079, a little lower than the median projection of CNY6.7084 from the Bloomberg survey.

Separately, note that the Philippine central bank hiked by 25 bp as expected (to 2.50%), while Indonesia stood pat at 3.50%.

Europe

The preliminary PMI in the eurozone was weaker than expected. The manufacturing PMI ticked down to 52.0 from 54.6. The German reading fell to 52.0 from 54.8 and the French reading fell to 51 from 54.6.

The aggregate service PMI dropped to 52.8 from 56.1. Germany's stood at 52.4, off from 55.0. France's was at 54.4, down from 58.3. The composite reading for the region stood at 51.9 compared with 54.8 in May.

Germany's composite fell for the fourth consecutive month and stood at 51.3 (from 53.3). France's composite fell for the second consecutive month to 52.8 from 57.0. By the time the ECB meets in September, where a 50 bp move may be on the table, was it unreasonable to suspect the PMI will be below the 50 boom/bust level? 

The UK flash PMI was mixed. The manufacturing PMI fell to 53.4 from 54.6. However, the services PMI was steady at 53.4. The market had looked for a small decline. The result was that the composite was also unchanged at 53.1.

Meanwhile, two byelections were being held today and polls warn that the Tories could lose both. If so, the results will further tarnish the Prime Minister, whose ability to lead the Tories into victory in the next election will be questioned.

Norway surprised many with a 50 bp hike today. The majority of those surveyed by Reuters and Bloomberg anticipated a quarter-point move, which the central bank had previously indicated. The deposit rate stood at 1.25% now and Norges Bank said a 25 bp hike in August was likely.

It now saw the key rate at 3% in the middle of next year, up from 2.50% it had previously projected for the end of 2023. It cut its GDP forecast and raised its inflation forecast.

The focus turns to Sweden's Riksbank that meets next week. It has only hiked rates once and at 0.25% it seems out of line with the 7.3% headline inflation and the 5.4% pace of the underlying rate excluding energy.

The euro was trading heavily but within yesterday's broad range (~$1.0470-$1.0605). There were options for 1.8 bln euros at $1.05 and around 1.4 bln euros at $1.0455. After trading up to $1.0580 in Asia and early Europe, the single currency sold off after the PMI report. It stabilized but was now likely to find the $1.0540 area as the nearby cap. The price action also underscored the more formidable cap at $1.06.

Sterling was also trading lower and was within yesterday's range (~$1.2160-$1.2315). But this did not do justice to the large consolidation. For the fifth session, sterling remained within last Thursday's range (~$1.2040-$1.2405). Immediate resistance was seen in the $1.2240-$1.2260 area in North America.

America

Some argue that in his testimony before Congress, Powell represented the Federal Reserve not just his opinion. Fair enough, but surely at the press conference after the FOMC meeting he was explaining what the FOMC decided and talked about its median projection. Maybe it was too fine of a distinction, but in any event, Powell's remarks in answer to the Senator's questions seemed somewhat more dovish and more cognizant that the effects of the tighter financial conditions were beginning to have the desired impact.

The Fed Chair seemed to play down supply chain bottleneck and sharpened his focus on demand, which lent support to some political arguments that the American Rescue Act.

At the press conference following the FOMC meeting, Powell seemed to acknowledge that among large countries, US inflation was in the middle of the pack, and that fiscal stimulus could not explain the relatively modest inflation differentials.

Yet, what may be more relevant for the foreign exchange market was Powell's answer to a question from Senator Warren. Powell explained that the Fed's goal of weakening demand was being pursued over three channels. The first was reducing the demand for interest-rate sensitive spending. Housing, autos, and other durable goods come to mind.

The Fed wanted to see a weaker sale. The second, weakening asset prices to curb the wealth effect and reduce the wherewithal to spend. This meant weaker stocks (so much for the Fed put), higher interest rates, and lower house prices.

It was the third channel that was arguably most notable—a strengthening dollar. He recognized that the changes in the exchange rate influenced import and export prices. By suggesting that the strong dollar was part of the fight against inflation Powell seemed to reduce the likelihood, which was not particularly high in the first place of intervention, to check the dollar's rise.

To say it somewhat differently, US participation or support of intervention to weaken the dollar was unlikely as long as the Fed was tightening financial conditions. It also meant that the strong dollar policy was alive and well.

That made a good segue into today's release of the US Q1 current account balance. It was going into a blowout deficit. The median forecast in Bloomberg's survey was for a whopping $275 bln deficit. Last year it averaged $205.4 bln a quarter. In 2018, the current account deficit averaged slightly less than $110 bln a quarter and in 2019, the average was about $118 bln.

As we have noted before, according to the OECD's purchasing power parity model, the euro, yen, and sterling were most under-valued in at least 30 years. Few talk about the current account deficit that was approaching 4% of GDP.

When the dollar was strong, the narrative was about interest rate and/or growth differentials. When the dollar falls, the twin deficits were often part of the narrative. We imagined the dollar's bottom will be a process that takes some time to form and that the markets will anticipate the peak in inflation and rate. Interest rate differentials often turn before the dollar.

If the key to the Fed's decision to hike by 75 bp instead of 50 bp was based on the CPI and preliminary University of Michigan's June consumer inflation expectations, then the significance of other high frequency data points was somewhat less important.

That included today's preliminary PMI, where the composite was expected to have fallen for the third consecutive month. The decline will likely put it at its lowest level since January, which itself was the lowest since July 2020.

Canada's strong jobs report earlier this month and strong retail sales and firmer than expected inflation did not help the Canadian dollar very much. Its sensitivity to the general risk environment has weighed on it, and although rising oil price did not seem to help it either, some were attributing the heaviness now to the drop in crude prices.

The swaps market had a 75 bp hike early next month nearly fully discounted. The US dollar was chopping between CAD1.29 and CAD1.30. It had reached almost CAD1.3080 last week. While some observers point to a double top in place, the problem was that it would not be confirmed until CAD1.25 goes.

Meanwhile, it was a big day for Mexico. The biweekly CPI through mid-June followed by April retail sales were to be released today. But the big event was to be the Banxico meeting, and regardless of today's data, a 75 bp hike was expected.

The central bank may also signal its intent for a similar move when it meets next on Aug. 11. The US dollar fell to a seven-day low near MXN20.00 yesterday. It recovered to almost MXN20.1425 today. Yesterday's high was near MXN20.25. A break of MXN20.00 could spur losses toward MXN19.90.