Prepare for 75bp Hikes, Strong US Economic Data, and New UK PM

US – Europe – $-Bloc and Scandies – China/Japan

US

Summary

• Employment Cost index to show labor market is heating up further.
• GDP to show growth acceleration.

Fed

This week, the Beige book confirmed that the wage price spiral is getting more entrenched.  In addition, the divide between hawks and doves became clearer with Kashkari saying that the Fed won’t stop at 4.75% if core inflation is not slowing.  At the other extreme Daly argued that the Fed should start talking now about slowing the pace of hikes.

Markets pricing of the terminal rate ebbed and flowed through the week but what was consistent was a flattening of the 2023 FFR curve.  My expectations remain 75bp at the next two meetings, which I will explain in my Fed preview this week.

Next week is the pre-meeting blackout (Waller is speaking but on FedNow, the Real Time Gross Settlement system the Fed is putting in place).

Data

There was not much going on this week data wise.  Despite the decline in home sales, the inventory of homes for sales continued to fall MoM and YoY, as I expected.

This week the two most important data points are the Employment Cost index (ECI) and the first Q3 GDP estimate.

Q3 ECI (Friday): The ECI is the Fed preferred measure of wage growth because it takes into account changes in the distribution of wages. The Fed views wage inflation as a key driver of core services and therefore core inflation. I disagree with the consensus showing 1.2% QoQ, against 1.3% QoQ in Q2. I think wages are more likely to have accelerated than slowed due to the tight labor market and accelerating inflation. In any event, public sector wages have been lagging, the private sector and the Fed is likely to pay more attention to the latter than the former. Q2 private sector ECI was 1.5% YoY, up from 1.4% in Q1.

Q3 GDP (Thursday): I am okay with the consensus 2.3% QoQ (the Atlanta Fed nowcast shows 2.9%).  I will be looking for an acceleration in final sales to domestic suppliers and in GDI.  The GDP is a backward looking variable but is still important because it will provide a baseline for the Fed estimates of capacity pressure.  The Fed is looking for H2 growth to fall below their LT estimate of 1.8%.

Other key data:

• Production data – Chicago Fed National Activity Index (Monday), S&P Global PMI (Tuesday), Richmond Fed Manufacturing Survey (Tuesday), Kansas City Fed Manufacturing Survey (Thursday): I agree with the consensus.
• CB Consumer Confidence (Tuesday): I agree with the consensus and will be looking for a further increase in the jobs plentiful minus hard-to-get index.
• Real estate data – FHFA and Corelogic Home Price Indices (Tuesday), Mortgage Application Index (Wednesday), New Home Sales (Wednesday), Pending Home Sales (Friday): I agree with the consensus.
• Goods Trade Balance (Wednesday): the consensus showing almost no change seems too pessimistic, the trade balance is improving quickly due to reshoring.
• Inventories (Wednesday) and Jobless Claims (Thursday).
• Durable Goods Orders (Thursday):  I will be looking for a continued pickup in non-defense capital goods orders.
• PCE Inflation (Friday): I agree with the consensus.
• Personal Income and Spending (Friday): I am okay with the consensus that implies a continued low savings rate. I will be looking for a continued pickup in real personal income excluding government transfers.

Events/Political Developments

The Supreme Court has allowed the administration student debt forgiveness plan to proceed.  Under the government accounting rules, the full cost of the measure of about 1.5% of GDP, had to be recorded in September, even though the cash flow impact will take place over a number of years. As a result  the FY2022  deficit is now $1.4tn or 5.6% of GDP against $2.8tn or 12.4% of GDP in FY2021.

Election polls continue to show the GOP as likely to win the House. In the senate, the polls have moved in favor of Republicans: the Senate is now viewed as a tossup from previously likely to remain Democratic. 

Links to New York Fed POMOs/TOMOs:  Repos, Treasury, MBS, CMBS

Europe

Key Points

• New UK PM elected.
• Expect the ECB to hike 75bp. The capacity for the EC to move towards QT may be limited, but that doesn’t seem to be stopping them discussing it. Upside to yields to continue.
• European PMIs to remain in contractionary territory.
• European inflation to move another leg higher – big question is whether month-on-month inflation momentum is sustained after September’s spike.
• BoE speakers may begin to push back on market pricing.

New UK PM – Will Boris Return?

With the rules set out, the new UK PM is scheduled to be confirmed by Friday. The first hurdle for prospective candidates to cross (currently Rishi Sunak, Boris Johnson and Penny Mordaunt, of whom only the last has officially entered the race) will be to get 100MPs to back them. This will almost certainly whittle down the number to two, although it may even be enough to announce a winner.

Much is uncertain at this stage, although the assumption for now is that no candidate will seek to significantly upturn the fiscally prudent approach that Chancellor Hunt has laid out. The bigger risk may be that they delay the 31 October budget given the tight time period in which they will have to review and approve it following the election.

ECB Likely to Hike 75bp

The backdrop of worsening economic activity is doing little to prevent the ECB from sticking to its hawkish tone. More pressing will be the ongoing rise in inflation, which continues to significantly overshoot their forecasts (Chart 1). The forecasts have been poor. With the Governing Council fully accepting this, they will continue to focus on the current reading rather than their forecast trajectory. On that front, expect a 75bp hike at this meeting, and suggestion that this pace will be sustained if required. This is largely what the market is pricing.

The question elsewhere, is for how much longer they can sustain the talk of QT. This may seem a premature issue to worry about, given they have only just begun to discuss it, but pursuing such a policy dogmatically would inflict serious pain on EGBs. The reality is that the market is going to have to deal with a lot of additional EGB duration even without the ECB running down its balance sheet. At this stage, we are probably moving into the risk of the ECB overpromising and paring back later. Lagarde is now hard on the hawkish war-path. She was burnt on the way here pretending she could commit to fewer rate hikes than she could. It may be that eventually she is burnt again promising more QT than is feasible. Until that point, there is value positioning for higher yields.

Eurozone Inflation Momentum Continues

Eurozone national inflation rates have been capped through the year by national policies to limit price rises (in energy, transport etc.). Such action has continued, but finally we are beginning to see the momentum in underlying price pressures rise. September showed an unseasonal rise in inflation (both core and headline), partly driven by gas price moves (Chart 2). The question now is whether such momentum in the underlying indices has continued. This week we will see national inflation readings which will inform us on this front. Expectations are for the rise to have decreased, but remain strongly above average. That could be enough to drive more pricing into the ECB terminal rate, and enough to keep Lagarde from wanting to show any signs of pivoting dovish.

PMIs to Show Continued Economic Malaise

October preliminary PMIs are expected to show that the economic slowdown continues in the UK and EZ. This will make little difference for either CB at present, with both having come around to the reality that recessions are close to inevitable.

Will the BoE Push Back Against Terminal Pricing?

The BoE is in a sticky position. Just as the more neutral voices began to pivot more hawkish, the rug was pulled from under them. What is left of the fiscal package remains supportive of the consumer, so all equal it suggests strong action in November, but just how strong remains to be seen. There is a good chance that Chief Economist Pill (speaking Tuesday) begins to temper some of his language at least on that front. Broadbent, speaking last week provided the first signs that even with a large move in November, the market may be pricing too much into the terminal level. This pricing has pushed 2Y mortgage rate fixes up to 6%, which feeds directly into consumer disposable incomes. The longer they are allowed to remain at such rates, the greater the risk of substantial consumer damage. With energy bills no longer assured beyond 6 months, that may be enough to merit some more tempering dovish talk from Pill.

$-Bloc and Scandies

Central Bank Watch

Reserve Bank of Australia

Australian employment steadied through September – employment (+0.9k) ticked higher while the unemployment (3.5%) remained a touch above record lows – a relief to the RBA. There is a risk of a lower October reading following recent floods.

Aside from data, Deputy Governor Bullock addressed policy making at the central bank. It gave us an eye into their Blackbox, and importantly the datasets they tend to monitor. Indeed, while we now receive monthly CPI updates (recall, they officially care about the quarterly print), we are yet to see a similar step by the ABS for the Wage Price Index. As a result, they have paid close attention to alternative data sources: the business liaison program (something we hear of. Data is little shared, so the adjoining graph was a pleasant surprise), NAB and AIG business surveys, CBA wage indicator, Xero small business indicator, and the SEEK Advertised Salary Index.

We expect the RBA to hike by 25bp on 1 November. Further afield, we see a low likelihood of a wage-price spiral in Australia, which should limit the terminal rate. The market is now pricing in the higher end of our expectations for the terminal rate (3.25%-3.5%).

Trade idea: AUD/USD could fall to 0.60.

Bank of Canada

The Bank of Canada Consumer and Business survey proved fruitful. Governor Macklem wanted long-term inflation expectations to remain reasonably anchored – they touched lower (Chart 3). Other inflation data proved encouraging too (Chart 4). However, markets attached themselves to the September inflation update. While Canadian inflation slowed (6.9% YoY vs 7.0% YoY previously), and remained lower than the bank forecasted in July, it was not as fast as markets had expected (6.7% YoY; Chart 5). Moreover, the other half of Governor Macklem’s wish list – for core inflation measures to meaningfully ease – failed to provide any early present.

With core inflation yet to reside, it will be easy for the board to side with market expectations for another 75bp hike on Wednesday (26 October). We do think, however, markets are underpricing the risk that they decide for a smaller sized move – in line with our original expectations.

Trade idea: AUD/CAD could fall to 0.85, or lower.

Reserve Bank of New Zealand

New Zealand inflation thundered higher, at a pace not expected by the market or by the Reserve Bank of New Zealand (RBNZ). As a result, we expect the RBNZ to hike the Overnight Cash Rate (OCR) to 4.25% (+75bp) on 23 November, with work to continue in 2023.

Trade idea: The parity trade your forgot about: AUD/NZD.

Norges Bank

We expect Norges Bank to hike by 25bp in November, though it is at risk of being replaced by a 50bp hike.

Trade idea: EUR/NOK is overvalued, but not overdone (yet).

Riksbank

The labour force update scored points for the hawks and doves; while the unemployment rate remains well below forecast, the employment rate is now lower than expected (Charts 7 and 8). We expect that the Riksbank is likely to follow with (at least) 50bp in November and 25bp in February. This would take it to the forecasted 2.5%.

Calendar Preview

Here are the key events to watch:

Australia

• Australian Budget (Tuesday, 09:30 BST): It will do little to the inflationary look and is expected to have no major policy announcements. Instead, it will focus on major election policy changes and revised economic forecasts.
• Inflation (Wednesday, 01:30 BST): It has the potential to surprise to the downside, depending on how electricity rebates are treated. Further afield, inflation may prove more persistent than first thought with floods causing havoc with food prices.

Canada

• Bank of Canada (Wednesday, 15:00 BST): We expect a 75bp hike, though note that markets are underpricing the risk of a smaller (50bp) sized move.

New Zealand

• ANZ Business Survey (Wednesday, 01:00 BST): The survey will be under close inspection – especially inflation expectations following the larger than expected CPI print.

Norway

• Unemployment (Friday, 09:00 BST): At 1.6%, it remains 0.1pp below forecast.

Sweden

• A quiet week here.

China/Japan

The BoJ is holding its policy meeting next week and no change in policy is expected.

Key data releases this week include China’s industrial profits.

Links to BOJ Rinban , BOE OMO

Due to the administration declaring the end of the pandemic I am ending my Covid monitoring for now.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Ben Ford is Researcher at Macro Hive. Ben studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)