We have not heard from the Federal Reserve recently because of the blackout period ahead of next week's FOMC meeting, but we suspect that they are likely going to be aggressive with more ‘forceful' monetary tightening commentary to address inflation as oppose to a September pause. Feeding into this theme will be today's US May CPI number. The White House has warned this will be a high number and consensus expects the headline reading to remain at 8.3% year-on-year, while the core rate should dip to 5.9% YoY from 6.2% YoY. We see inflation staying sticky. Any upside surprise to the monthly core rate will likely drive short-term US rates and the dollar higher and lead to a hawkish FOMC next Wednesday.
The overriding need to fight inflation with higher real interest rates remains a headwind for risk assets, where equities suffered on both sides of the Atlantic yesterday. This cautious risk environment should continue to favor the dollar and dominate markets in the near term.
Jobs data for the month of May will be released today, and we expect a stronger headline figure than the 15k increase in April, fuelled by a rebound in full-time employment, as well as some further acceleration in wage growth. Observe the USD/CAD chart.
The notion of a tight market has been central in allowing the Bank of Canada to push forward with 50bp rate increases, and we think today’s release will continue to endorse a fast-paced tightening cycle. With rate expectations supported and crude prices enjoying good momentum, we think the Canadian dollar can stay on an appreciating path. We think a break below 1.2500 is likely in the coming days, and we expect sub-1.2500 levels to be the norm for the second half of the year.
We think the European Central Bank (ECB) will be disappointed by the euro's reaction yesterday. We had felt that the hawkishness seen since late April had been an effort to narrow rate differentials with the US and to get EUR/USD higher. The ECB delivered a hawkish update yesterday, eurozone interest rates rose - yet the euro fell. There seems to be a risk premium being built into the euro now - i.e. EUR/USD is trading some 1.5/2.0% lower than where short-term fair value models suggest. For today, a firm US CPI print and higher short-term US rates could break EUR/USD below 1.0600 in a move to the 1.0500/0520 area.
The fact that money markets still price a further 175bp of Bank of England (BoE) tightening by year-end goes to show that investors struggle to buy into the idea of a pause anywhere. We have heard very little from the BoE over recent weeks, questioning whether there is to be a rude awakening on the BoE rate profile when the Bank announces rates next Thursday. GBP/USD one-month volatility is trading at 9.4% - and we could easily see traded volatility rising back to 11-12% levels given huge uncertainty over coming weeks. We could see GBP/USD breaking down to 1.2350 next week.
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