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View from the Trading Desk:
Last week's risk rally is rather confounding to anyone that's looked beyond the headline US Consumer Price Index print, which showed price pressures cooling ever so slightly for the month of July. Understandably, some economists have called a peak to the current bout of inflation, considering the drop-off in energy and food prices. Still, core inflation looks sure to stay elevated above the Federal Reserve's target for the foreseeable future. More concerningly, market expectations of a 'dovish' Fed pivot have eased financial conditions, which supports asset prices while complicating the picture for officials that have pledged to raise rates until the 2% target is in sight.
All things considered, we would posture that calling the 'peak' is not the critical issue at hand, and while headline numbers in the US may have topped out, it's short-sighted to base a rally off that alone. Core inflation may or may not have also peaked, but underlying components, including housing and autos, showed few signs of abating. And that's where the problem lies. If month-on-month prices continue to fall at their July rate, it's estimated that inflation will still be running at over 6% by year-end. It's no wonder the University of Michigan's long-term inflation expectations increased in Friday's report.
Looking closer to home, Wednesday's headline UK inflation print, expected to hit 9.8% for July, will offer no help to the already bleak outlook. Prices in the UK are peaking both higher and later than in the US, thanks to the price-cap mechanism, which delays the transfer of higher energy prices through to consumers. The Bank of England, which has forecasted seven consecutive quarters without growth to start later this year, expects price gains to peak at 13.3% this year and remain around 10% in a year's time. Yet, markets have already begun to price in a BoE pivot which would see them ease conditions midway through 2023 on the back of a probable recession.
Bottom line: Sterling had gained over 1.5% against the Greenback after last week's US CPI print, but with multiple risk events in the offing, has slipped back toward the 1.2050 interbank level. This week, stronger than expected reads for labour and/or inflation data could offer the Pound some much-needed support, but we'd be wary of that turning into a more sustained rally unless the pair can break through the 1.23 handle.
The week ahead
Last week’s data was all surprisingly better than expected, which included Industrial Production, Business Investment, and so forth. Unfortunately, it had little impact on the Pound, which has continued to trade sideways while the UK political sideshow between Rishi Sunak and Liz Truss plays out. The main driver for Sterling will likely continue to be inflation, which is sapping consumption and necessitating a hawkish Bank of England policy stance.
- UK employment data will be released on Tuesday morning with little change expected, except a noticeable decline in average earnings.
- On Wednesday, inflation data will be the highlight of the week. The Retail Price Index is also due out and is expected to top out at 12% y/y.
- On Friday, Retail sales are anticipated to post another month-on-month decline.
Last week was a very quiet one for the EU with very little data on offer. No surprise then that Euro traded flat most of the week. The stock rally heading into August was likely to require a period of consolidation anyway, but the quiet August environment was the clincher.
- On Tuesday, ZEW economic sentiment reading for Germany and Europe are expected to reach new lows, which are just short of the all-time lows seen during the Financial Crisis.
- Flash Employment Change and Gross Domestic Product q/q will be released on Wednesday. These lagging indicators are less likely to be market movers.
An unexpected drop in Producer Prices caused a positive stir in markets hoping it means a topping of inflation. We also saw some Federal Reserve members chime in with suggestions that they would support a slowing in hikes, which caused a retreat in both risk-off and the Greenback.
- On Tuesday, we expect a range of housing data that will likely show a slowdown in construction. And more importantly, we’ll also see Industrial Production print which is expected to bounce back into positive territory.
- On Wednesday, Retail Sales are expected to decline to marginally positive. The Fed will be watching any data points relating to consumer behaviour very closely.
- We’ll also see minutes from the Fed’s last meeting on Wednesday, which will give some greater context into their new no-holds-bar approach to stamping out inflation.
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