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US inflation key to the pace of future Fed tightening

 Today’s news headlines

  • ‘Bolsonaro wins first round of Brazil’s Presidential poll’. Former Army Captain, Jair Bolsonaro, won a resounding victory in the first round of Brazil’s presidential election, raising the prospect of a return of the far-right in the country. (Financial Times)
  • ‘UK would be welcomed to TPP “with open arms”, says Abe’. The Japanese Prime Minister, Shinzo Abe, urged compromise to avoid a no-deal Brexit. (Financial Times)
  • ‘Kavanaugh becomes rallying cry for left and right’. Supreme Court appointment marks new flashpoint in already bitter US midterms. (Financial Times)
  • ‘China cuts some banks’ reserve requirements to spur growth’. China’s central bank said it would cut the amount of cash some banks must hold as reserves to lower financing costs and spur growth. (CNBC)
  • ‘Italy holds strong to budget position ahead of EU deadline’. Deputy Prime Minister Luigi Di Maio sees softening of rules after 2019 EU Parliament vote. (Bloomberg)

The focus on Friday was the US September employment report, which created financial market repercussions that spread far beyond the US and into the following trading sessions. The mixed report was met with a mixed financial market reaction. US Non-Farm Payrolls fell to 134K in September below expectations of a 185K print. However, the headline miss was more than offset by a combined 87K upward revision to the prior two months’ payroll figures. The unemployment rate ticked lower to 3.7%, a near five-decade low. The participation rate remained unchanged at 62.7%. The failure of the participation rate to increase further may explain the weaker than expected September payroll number, despite an overwhelming majority of surveys suggesting strong labour demand from US companies. The US may be running out of labour to fill vacant positions. Weekly average earning growth slipped to 2.8% in September, as expected.

The US employment report was strong; headline Non-Farm Payrolls plus backward revisions reported an extra 221K jobs in the US. The Unemployment Rate hit a historic low. The one-off impact of Hurricane Florence during the month also suggests that these figures underestimate the real strength of the labour market in September. The resultant varied market reaction speaks more about elevated expectations and extended positioning than the strength of the US job market.

The trade-weighted Dollar initially traded lower on the headline Non-Farm Payroll miss, before retracing its losses, then selling off again. It is currently reversing those losses in the Monday Asian open. Stock markets traded lower globally responding to the risk-off tone. However, US yields made consistent gains following the release. The US 30-year yield gains 5.0bps with the 10-year yield higher by 4.7bps. Rates markets also marginally increased their expectations of policy tightening, rising to 67bps from 66bps before the release.

The one concern within the report was the tick lower in Average Hourly Earnings. A stronger Dollar is depressing US non-oil import prices meaning inflationary pressure must be domestically generated. A large portion of this depends on wage growth. Wage growth needs to rise to 3.0-3.5% to sustain inflation at the 2.0% target. With this mind, US Producer Price Indices (PPI) and the Consumer Price Index (CPI) released this week will be the key focuses for markets and the Federal Reserve. We know the US labour market is strong, so it is inflation that will set the pace of future Fed policy tightening.

Sterling had one of its strongest performances last week on rumours that the UK and EU were close to reaching a Brexit agreement and that a Withdrawal Bill could soon be agreed. While a soft orderly Brexit remains our base case, we are cautious about piling into Sterling longs without any substantiated evidence that a UK-EU deal is in the works. Sterling at these lofty levels is very much at risk of one or two negative Brexit headlines.

The US Columbus Day holiday today means Monday’s trading session will lack any US data releases. The typically illiquid environment could lead to abrupt currency moves. However, Australia’s September ANZ Job Advertisements and Foreign Reserves data have been released overnight. Switzerland’s September Unemployment Rate and October 5th Domestic Sight Deposits numbers will also reach markets. An increase in Swiss domestic sight deposits indicates the central bank has intervened in FX markets to weaken their currency. Though, Italy’s recent backtrack of government spending plans suggests the central bank may no longer need to be on standby to hit the printing press. The uber-dovish Federal Reserve’s James Bullard is due to speak in the morning. The media Q&A following his speech may allow Bullard’s dovish view of the US economy to counter the recent hawkish commentary coming from the central bank.