FX Majors Weekly Outlook (25-29 July)

UPCOMING
EVENTS:

Tuesday: US
CB Consumer Confidence.

Wednesday:
FOMC Policy Announcement.

Thursday: US
Q2 Advance GDP.

Friday: US
PCE.

We closed
the last week with surprisingly awful US PMI data. The services index in
particular fell much lower than expectations to 47 from the prior 52.7 a month
earlier. That is a very fast deterioration and at a rate not seen since 2009
amid the global financial crisis. Generally, it’s the Manufacturing sector that
falls faster as it’s more cyclical than the Services sector even if it accounts
for just 20% of consumption. The Services sector though accounts for a huge
80%, which highlights even more how awfully the economy is performing.

The US
economy may already be in recession and we may get a confirmation of that on
Thursday when we will get the US Q2 Advance GDP report, which according to the
Atlanta Fed GDPNow model, is likely to show another negative print.
Technically, two consecutive quarters of negative GDP is considered a
recession.

Having
considered all of this, the market is likely to return to a risk off sentiment
this week. There’s a common thought that bad news now is good news as the Fed
is more likely to pause or even start cutting interest rates as the recession
will bring inflation down. That absolutely makes sense and in recent recessions
worked well, but the problem this time is that inflation is much higher and
broader. I think the Fed will want to see clear evidence of inflation getting
back to target before signalling a pause or the start of a cutting cycle. This,
of course, will make the recession even worse and translate into more risk
aversion in the market.

Some also
say that falling yields are good for the stock market but do not consider the
context. Yields in this case will fall as the market will see such a bad
contraction that the Fed will pivot earlier than expected. The stock market in
such cases falls together with yields as the economy worsens badly. Below you
can see a chart of the two recent notable recessions.

S&P500 (Blue Line)
vs. US10Y (Orange Line)

To sum up, I
think this week will mark the end of the relief rally we saw the last week
after Fed’s Waller comments and the lower than expected long-term inflation
expectations in the UMich survey.

On Tuesday
we get the US Conference Board Consumer Confidence report which is expected to
deteriorate further.

On Wednesday
we will have the main event of this week, the FOMC Policy Announcement. After
an initial pricing of a 100 bps hike after the hot CPI report, the market
quickly switched back to expecting a 75 bps hike as comments from the two most
hawkish Fed members, Waller and Bullard, signalled a more conservative approach
and economic data like the long-term inflation expectations in UMich survey,
the housing data and PMIs further cemented the expectations of a 75 bps hike at
this meeting.

Given that
the Fed now is more focused on inflation than growth and that the next FOMC
meeting is two months away, there’s still a little chance that they go for 100
bps and see what the next two inflation reports will show before the September
meeting. They may think that the risk of hiking less and get two hot inflation
reports after, may be greater than going for 100 and then see an easing in
inflation. On the other hand, the Fed generally follows market expectations
because it doesn’t like to surprise, so a 75 bps is comfortably the base case.

Markets are
currently pricing in a year-end Fed Funds rate at 3.25-3.50%, which is also the
market-implied terminal rate with rate cuts priced in Q1 2023.

On Thursday
we will get the above-mentioned US Q2 Advance GDP report, which is expected at
a positive 0.5% annualised rate. The Atlanta Fed GDPNow model points to a
negative 1.6% estimate.

On Friday we
will see the Fed’s preferred measure of inflation, the Core PCE. The M/M rate
is seen rising 0.5% compared to the previous 0.3%, while the Y/Y figure is
expected at 4.7%, the same as the prior reading. We will also get the US ECI
(Employment Cost Index) which Powell has previously said it’s a key metric he
watches. The ECI is seen falling to 1.2% from the prior 1.4% and a higher
number would be unwelcomed for the Fed as it will increase their concerns
around a second-round inflation effects.

This article
was written by Giuseppe Dellamotta.