Dollar and U.S. Yields Take a Breather Ahead of FOMC Decision

U.S. yields and the dollar are taking a breather ahead of the FOMC decision; the two-day FOMC ends today with a rate hike; new macro forecasts and Dot Plots will be released; we also note that QT announced at the May 3-4 FOMC meeting starts today; May retail sales will be reported ahead of the FOMC decision; June regional Fed manufacturing surveys start rolling out; Brazil COPOM is expected to hike rates 50 bp to 13.25%
The euro is higher after the ECB announced an emergency meeting today in response to growing concerns about fragmentation; other reports suggest ECB officials recognize the risks of fragmentation but do not want to announce any specific remedies yet; we are shocked that the ECB wasn't better prepared for the fallout; ECB tightening expectations have picked up
Japan reported strong April core machine orders; Australia raised its minimum wage by more than anticipated; China reported firm May IP and retail sales data; Thai policymakers are split on the need for rate hikes

The dollar is softer ahead of the FOMC decision. DXY is giving up some of its recent gains after five straight up days, trading near 104.80 after making a new high for this move near 105.65 yesterday. We maintain our next target as the December 2002 high near 107.30. The euro is trading higher near $1.05 on news of an emergency ECB meeting to address fragmentation (see below). However, the ECB is likely to disappoint and so the May 13 low near $1.0350 remains in play. After that, we have to start talking about parity. The weakening trend in the yen has stalled, with USD/JPY trading back near 134.50 after making a new cycle high near 135.60 earlier today. As the pair hit our long-standing target of the January 2002 high near 135.15, we believe it is on track to test the August 1998 high near 147.65. Sterling remains heavy near $1.21 after breaking below $1.20 yesterday. We continue to target the March 2020 low near $1.1410. We expect the Fed to maintain a very hawkish stance today, which should continue to underpin the dollar.

AMERICAS

U.S. yields and the dollar are taking a breather ahead of the FOMC decision. The 10-year yield traded near 3.50% yesterday, the highest since April 2011, but is currently near 3.37%. Inflation expectations remain restrained and so as a result, the real 10-year yield rose to 0.82% yesterday, the highest since February 2019, but is currently near 0.72%. Elsewhere, the 2-year yield traded at a new cycle high near 3.45% yesterday, the highest since November 2007, but is currently near 3.29%. Global bond markets have settled down a bit, helped by news of the emergency ECB meeting (see below). However, further volatility is to be expected after today's FOMC decision (see below). When all is said and done, however, we believe monetary policy divergences remain the dominant driver for FX. As the U.S. economic outlook remains the best relative to its DM peers, the dollar uptrend remains intact.

The two-day FOMC ends today with a rate hike. Analysts are looking for a 50 bp hike. However, the Fed Funds futures market is pricing in a 75 bp move. Indeed, WIRP now suggests a follow-up 75 bp move July 27 is pretty much fully priced in as well. Then, 50 bp hikes September 21 and November 2 are fully priced in, followed by 25 bp hikes December 14 and February 1. Prior to the media blackout period, the Fed had signaled 50 bp moves at both the June and July meetings. It is now caught in a dilemma. Does it match market expectations or does it stick to the game plan? This is one of the reasons why policymakers should neither pre-commit nor take anything off the table. We thought 75 bp today was unlikely when this week began but it now seems likely as the Fed will feel compelled to meet market expectations. Looking ahead, the swaps market is now pricing in a terminal Fed Funds rate of 4.0%, up from 3.0% at the end of May but down from 4.25% at the peak of this week's frenzy.

New macro forecasts and Dot Plots will be released. We expect an extremely hawkish shift in the Dot Plots that will be justified by significantly higher inflation forecasts. Current Dot Plots see 1.875% in 2022, rising to 2.75% in both 2023 and 2024. If the Fed goes the faster route as markets are pricing, we'll be above 2.75% by September. Indeed, if the Fed sticks with the market pricing, Fed Funds will be around 3.75% by end-2022 alone and likely moving higher in 2023. Granted, market pricing is likely near an extreme right now but the Fed needs to signal that it is serious about tackling inflation. Hawkish forward guidance can always be walked back as the Fed needs to get ahead of the curve now. Lastly, we do not think the Fed will signal a recession over the forecast horizon that would result in a lower expected Fed Funds rate in 2024, as the Bank of England did recently.

We also note that Quantitative Tightening announced at the May 3-4 FOMC meeting starts today. The Fed's balance sheet will start shrinking and will ramp up quickly to a pace of $1.1 trln per annum. This is also very dollar-bullish on top of the ever-evolving Fed rate hike story.

May retail sales will be reported ahead of the FOMC decision. Headline sales are expected at 0.1% m/m vs. 0.9% in April, sales ex-autos are expected at 0.7% m/m vs. 0.6% in April, and the so-called control group used for GDP calculations is expected at 0.3% m/m vs. 1.0% in April. Sales have surprised to the upside for several months as consumption has held up well in the face of rising inflation and falling real wages. Indeed, the graph below shows how retail sales have accelerated well beyond the pre-pandemic pace. Can this be sustained? We'll know more today.

June regional Fed manufacturing surveys start rolling out. Empire survey starts things off today and is expected at 2.3 vs. -11.6 in May. Philly Fed reports Thursday and is expected at 5.0 vs. 2.6 in May. May IP will be reported Friday and is expected at 0.4% m/m vs. 1.1% in April. Despite the weak Fed surveys for May, the manufacturing sector remains in solid shape. May import/export prices, April business inventories, June NAHB housing market index, and April TIC data will all be reported today.

May PPI data came in lower than expected. Headline came in at 10.8% y/y vs. 10.9% expected and a revised 10.9% (was 11.0%) in April, while core came in at 8.3% y/y vs. 8.6% expected and a revised 8.6% (was 8.8%) in April. Both headline and core PPI decelerated for a second straight month, which matches the deceleration in core CPI reported last week. While there are some rays of hope in the May data regarding the inflation trajectory, it's way too early to get excited and the Fed still has a long road ahead in terms of tightening.

Brazil COPOM is expected to hike rates 50 bp to 13.25%. At the last meeting, COPOM hiked rates 100 bp to 12.75% but signaled future hikes would likely be smaller. The swaps market is pricing in another 150 bp of tightening over the next 12 months that would see the policy rate peak near 14.25%, up from 13.50% at the start of this week. IPCA inflation eased to 11.73% y/y in May vs. 12.13% in April, the first deceleration since December but still well above the 2-5% target range.

EUROPE/MIDDLE EAST/AFRICA

The euro is higher after the ECB announced an emergency meeting today in response to growing concerns about fragmentation. The bank will "discuss current market conditions" and is clearly a response to spiking peripheral spreads, which in turn have weighed on the euro. Reports suggest the bank will look to finalize its plan announced last week to use PEPP reinvestments to tackle fragmentation, and will also discuss a broader strategy to address the problems facing the eurozone. As we noted last week, "If Italian spreads blow out, it will take a lot more than adjusting PEPP reinvestments to address it. Peripheral spreads are moving higher to new cycle highs, as they should after the ECB brought a slingshot to a bazooka fight."

Other reports suggest ECB officials recognize the risks of fragmentation but do not want to announce any specific remedies yet. Officials on the Governing Council reportedly believe that there aren't any real benefits to preemptively reveal any specific crisis tools and instead could simply lead markets to test the bank's resolve. Instead, ECB policymakers reportedly would rather wait until a specific threat materializes, in which case there would be a strong response as needed. While we understand the ECB's reluctance to divulge any specifics, we are big believers in the bazooka approach. That is, the ECB should show markets that there is a bazooka in its pocket that's so large that no one will want to test it.

We are shocked that the ECB wasn't better prepared for the fallout. That they had to call an emergency meeting less than a week after its regularly scheduled meeting seems amateurish. To market observers, it's pretty clear the pledging PEPP reinvestments to address fragmentation would not be enough to quell the rising concerns. Why didn't the ECB see this? Peripheral spreads have come in a bit today on news of the meeting, but we are left with the feeling that the ECB is likely to disappoint once again. Stay tuned.

ECB tightening expectations have picked up. WIRP suggests a 25 bp hike July 21 is fully priced in. Then, 50 bp hikes are now fully priced in for September 8, October 27, and December 15 that would take the deposit rate to near 1.25% by year-end, up from 1.0% at the start of this week. Looking ahead, the swaps market is now pricing in 300 bp of tightening over the next 24 months that would see the deposit rate peak near 2.5%, up from 2.0% at the start of this week and 1.75% before the ECB meeting. April eurozone IP and trade data were reported. IP came in at 0.4% m/m vs. 0.5% expected and a revised -1.4% (was -1.8%) in March. However, the y/y rate still fell to -2.0% vs. -1.1% expected and a revised -0.5% (was -0.8%) in March. The trade gap came in at a whopping -EUR31.7 bln, more than double the expected -EUR14.5 bln and we suspect due largely to surging energy prices.

ASIA

Japan reported strong April core machine orders. They came in at 19.0% y/y vs. 5.3% expected and 7.6% in March. This is the second straight month of acceleration and bucks the slowing trend seen in machine tool orders. However, with both domestic and regional activity slowing, we suspect core machine orders will eventually fall in line with the slowing trend. We believe the Bank of Japan remains sensitive to downside risks to the economy and so is likely to maintain current policy settings at its two-day meeting that starts tomorrow.

Australia raised its minimum wage by more than anticipated. The national minimum wage was increased 5.2% starting July 1 to AUD812.6 ($560.08) per week, while the hourly minimum wage will climb to AUD21.38. While the increase is obviously meant to help households cope with the rising cost of living, we note that the 5.2% increase barely covers the rise in headline inflation. Still, higher wages and low unemployment are likely to keep the RBA on its aggressive tightening path. WIRP suggests a 50 bp hike is fully priced in for July 5, with nearly 30% odds of a 75 bp move. Looking ahead, the swaps market is pricing in 365 bp of tightening over the next 12 months that would see the policy rate peak near 4.5%, up from 3.5% at the start of this month.

China reported firm May IP and retail sales data. IP came in at 0.7% y/y vs. -0.9% expected and -2.9% in April, while sales came in at -6.7% y/y vs. -7.1% expected and -11.1% in April. The economy should continue to recover as movement restrictions are lifted but the recovery is likely to be uneven as restrictions will be enacted periodically to help limit any COVID outbreaks. Elsewhere, the PBOC kept its 1-year MLF rate steady at 2.85%, as expected. As a result, commercial banks are likely to keep their Loan Prime Rates steady at the monthly fix next week. May new loans and aggregate financing picked up but more easing needs to be seen. May CPI inflation continues to run below the 3% target and so the focus will remain on boosting the economy.

Thai policymakers are split on the need for rate hikes. Deputy Prime Minister Supattanapong Punmeechaow warned of risks to economic growth from higher rates, which stands in contrast to earlier comments from Bank of Thailand Governor Sethaput Suthiwartnarueput and Deputy Governor Mathee Supapongse, who both argued that hiking rates early will help avoid steeper hikes later. As we all know, it's widely held that politicians should never comment on monetary policy so that central bank independence is questioned. Recall the Bank of Thailand delivered a hawkish hold last week. It kept rates steady at 0.50%, as expected, but the vote was 4-3 with the dissents in favor of a 25 bp hike to 0.75%. The bank noted that "Headline inflation would increase and remain elevated for longer than previously estimated. The committee will assess the appropriate timing for a gradual policy normalization." Looking ahead, the swaps market is pricing in 75 of tightening over the next 3 months, which implies liftoff at the next meeting August 10. 275 bp of tightening is priced in over the next 24 months that would see the policy rate peak near 3.25%, up from 3.0% immediately after last week's meeting.

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