The Pendulum Between Inflation and Growth Fears Swung from One Extreme to the Other

Fundamental analysis of Forex market


Since the beginning of the year up until mid-June, investors turned a blind eye to growth risks, focusing solely on inflation developments and changing reaction functions of central banks (normalization/tightening). This resulted in an unseen core bond sell-off. Ever since even the SNB hiked its policy rate, attention turned to economic consequences of these price and monetary shocks. Especially with the European energy crisis adding a layer. Core bonds recovered, arguing that central banks would take this economic concerns into account during the inflation crusade.

The pendulum between inflation and growth fears swung from one extreme to the other. A chain of events this week triggered the start of a more neutral positioning. Better-than-expected earnings by US retailers – confirmed by July US retail sales – set things in motion. An hawkish signal from tightening-frontrunner RBNZ and especially the first double digit UK inflation outcome did the rest.

UK Gilts underperformed German Bunds and US Treasuries yesterday. UK yields rose by up to 25 bps at the front end of the curve yesterday, the 2-yr yield taking out the mid-June top. The German yield curve bear flattened with yields adding 6.2 bps (30-yr) to 15.4 bps (2-yr). The German 10-yr yield broke out of the downward corrective trend channel in place since Mid-June, suggesting more upside. Peripheral yield spreads showed weakness to the strong bond sell-off, widening by 7 bps for Greece and Italy.

Another victim from the selling was the stock market. They enjoyed a nice comeback over the past month and a half softer growth ironically beats the alternative of high inflation/extreme monetary tightening. Yesterday’s losses were up to 2% for Europe and up to 1.25% for the US. US yields rose by 2.4 bps (2-yr) to 9.9 bps (7-yr) with the belly of the curve underperforming the wings.

The front end performed better after dovish interpreted FOMC Minutes from the July meeting. The key sentence was that “Participants judged that, as the stance of monetary policy tightened further, it likely would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation”. We don’t want to read too much into this though as Minutes continue to flag the significant risk that the Fed might need to raise rates more than anticipated if inflation spreads more broadly than feared as well.

Action on main FX markets remained subdued in the volatile market environment. EUR/USD closed a tad higher at 1.018 (from 1.0171). EUR/GBP ended at 0.8448, up from 0.8408. Today’s eco calendar contains US Philly Fed Business Outlook and initial jobless claims. Markets recall the very weak Empire Manufacturing Survey earlier this week. It will be interesting to see whether a disappointing outcome will put the onus back on the growth fear. The Norwegian central bank meeting will be watched in a same vein as the New Zealand gathering earlier this week. An hawkish signal won’t go unnoticed.

News Headlines

July Australian labour market data disappointed. The Australian Bureau of Statistics reported the first fall in employment (-40.9k) since October 2021. Markets expected a 25k net job gain. Details were even worse as 86.9k full time jobs went bust whereas part time employment increased by 46k. The unemployment rate nevertheless fell from 3.5% to 3.4%, a 48-yr low, as the participation rate fell. Floods in New South Wales, winter school holidays and worker absences associated with Covid and other illnesses were at play. Head of labour statistics at ABS, Jarvis, pointed to an increasingly tight labour market, including high job vacancies and ongoing labour shortages. In July, there were fewer people unemployed (474k) than there were job vacancies (480k in May).The Aussie dollar barely reacted to the labour market, holding near sell-off lows around 0.6930 against the US dollar. AUD swap rates lose 4.8 bps (3-yr) to 2.2 bps (12-yr) with the belly of the curve outperforming the wings.

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