05/10/2024 Market Analysis

Week Ahead: U.S. Employment Surge Reinforces Fed’s Easing Path

Last week brought several important developments that will influence the investment landscape. First, the US September employment report exceeded expectations, reinforcing Fed Chair Powell’s stance. The Federal Reserve initiated an easing cycle with a 50 bp rate cut and is expected to proceed with two 25 bp cuts in Q4. Market expectations have now aligned with the Fed’s approach, rather than pushing for more aggressive cuts.

In Japan, both the government and the Bank of Japan are maintaining a cautious stance on near-term rate hikes. The market has adjusted its expectations, pushing the likelihood of the next rate hike into 2025, reflecting the BOJ’s patience.

The Eurozone’s September preliminary CPI fell below 2%, raising the chances of a rate cut by the ECB at their October 17 meeting. This signals that inflation is becoming less of an issue, potentially allowing for a more accommodative monetary policy.

In the UK, Bank of England Governor Andrew Bailey hinted at a faster pace of rate cuts, which weighed on the pound. However, market expectations remain unchanged, with a 60% chance of a 50 bp cut in Q4.

Geopolitical tensions have escalated, as Israel’s invasion of Lebanon and Iran’s missile strikes on Israel signal a widening conflict. Simultaneously, US oil inventories are at their lowest in over two years, driving oil prices above $75 a barrel, marking the highest level since August.

The US September CPI report on October 10 will be closely watched, with a slight 0.1% rise expected, which would bring the year-over-year rate down to 2.3%. Meanwhile, the Reserve Bank of New Zealand meets on October 9, where markets are pricing a 75% chance of a 50 bp rate cut. The UK’s August GDP report is also expected on October 11, potentially showing the first expansion in three months. Finally, Canada’s September labour market data, expected at the end of the week, may reveal job growth slightly above this year’s average.

United States of America

Strong Job Growth Lowers Unemployment

September’s job growth exceeded expectations, and the unemployment rate dropped. Another jobs report is expected before the Federal Reserve’s November FOMC meeting. As a result, the market has scaled back speculation of a 50 bp rate cut this year. Now, attention shifts to the upcoming CPI report on October 10.

CPI and Core Inflation Outlook

The headline CPI for September is expected to rise by around 0.1%, which would bring the year-over-year rate down to 2.1% from 2.5%. On a three-month annualized basis, the headline rate likely rose by 2% in Q3. Core inflation, however, remains more persistent. A 0.2% rise in core CPI could bring the annualized rate to 3.1%, down slightly from 3.2%, with a three-month rate of about 2.8%.

PPI and Trade Data Impact

The September Producer Price Index (PPI) will be released the following day, but it typically draws less market attention than CPI. Fed Chair Powell and Governor Waller have focused on CPI in explaining their rationale for the 50 bp rate cut, with PPI receiving less emphasis. Meanwhile, trade and inventory data for August will also be reported. The US trade deficit does not indicate weak exports; at around $2 trillion, US exports are second only to China’s. Goods imports dipped, while consumer goods imports rose, likely reflecting efforts to secure supplies amid potential disruptions, such as the dockworkers strike.

FOMC Minutes

The minutes from the Federal Reserve’s decision to start the easing cycle with a 50 bp rate cut will be released. Some critics argue that the Fed panicked and should have acted sooner, cutting rates in July. However, Powell and Waller have emphasized that the CPI data drove the decision to move from a 25 bp to a 50 bp cut. The minutes may provide further insight into this rationale.

Dollar Index Rally

The Dollar Index saw its strongest weekly gain in two years, rising by approximately 2.2% last week. It climbed every day, reaching a high of nearly 102.70 before the weekend, forming a base that could aim for the 104.00 level. However, some consolidation may occur at the beginning of the new week, with support likely around the 102.20 area.

Key Points:

• Strong US job growth reduces market expectations of a 50 bp rate cut.
• September CPI is expected to show modest inflation, with core inflation still sticky.
• The US trade deficit reflects supply chain security efforts, not weak exports.
• FOMC minutes will clarify the Fed’s reasoning for the 50 bp rate cut.
• The Dollar Index posted its best week in two years, signalling potential gains.

Australia & New Zealand

Diverging Central Bank Policies

The Bank of Canada may be one of the most dovish central banks in the G10, but the Reserve Bank of Australia (RBA) stands out as one of the least dovish. Governor Bullock continues to insist that it’s too early to consider a rate cut, and the market is starting to adjust its expectations. Futures market pricing shows about a 45% chance of a rate cut by the end of the year, down from 70% just a week ago. The minutes from the latest RBA meeting will be released on October 8. While the statement dropped any mention of raising rates, the overall message is expected to remain consistent.

Reserve Bank of New Zealand’s Easing Path

The Reserve Bank of New Zealand (RBNZ), on the other hand, is taking a more aggressive approach. With a meeting on October 9, the swaps market is pricing in a 75% chance of a 50 bp rate cut. The RBNZ has two meetings left in Q4, and markets have priced in 94 bp of reductions by year’s end, signalling a more dovish stance compared to its Australian counterpart.

Currency Movements

The Australian dollar hit a high of $0.6940 early last week but settled around $0.6800 by the end of the week. As the Aussie retraced, it approached the halfway point of its rally from September 11, found near $0.6780. A break below that level could lead to a move toward $0.6750 or even $0.6700. On the upside, resistance is likely around $0.6840.

Meanwhile, the New Zealand dollar dropped sharply, losing 2.8% last week and ending slightly below $0.6150. Support may come in around the $0.6100-$0.6115 range, but a further drop could see it test $0.6050.

Key Points:

• The Reserve Bank of Australia is holding firm, with market expectations for a rate cut decreasing.
• The Reserve Bank of New Zealand is leaning towards rate cuts, with markets expecting significant easing this year.
• The Australian dollar has pulled back after a recent rally, while the New Zealand dollar has seen sharp losses.

Canada

Bank of Canada Poised for 50 bp Rate Cut

The Bank of Canada seems likely to implement a 50 bp rate cut at its upcoming meeting on October 23, assuming no surprises from the September CPI report due on October 15. With the August merchandise trade balance and September employment data not posing major obstacles, the stage is set for easing. Canada’s goods trade deficit has narrowed through July to around C$1.4 billion, down from C$4.9 billion earlier in the year. However, the labour market is showing signs of slowing, with full-time job growth in 2023 running at only a third of last year’s pace. The unemployment rate has also risen from 5.7% in January to 6.6% in August.

Political Pressures and Economic Outlook

Political pressure is mounting on Prime Minister Trudeau’s minority Liberal government, with the possibility of a confidence vote looming at the end of the month or in early November. The Bloc Quebecois have indicated they may vote against the government, adding further uncertainty to the political and economic outlook.

Canadian Dollar

Despite losing around 0.4% against the US dollar last week, the Canadian dollar was still the best-performing currency among the G10. The Canadian dollar typically strengthens on the crosses when the US dollar is firm. After bottoming near CAD1.3420 in late September, the US dollar climbed to almost CAD1.36 by the weekend, where the 200-day moving average lies. Initial resistance levels are found at CAD1.3620 and CAD1.3650.

Key Points:

• The Bank of Canada is likely to cut rates by 50 bp, barring any surprises from upcoming economic data.
• Canada’s trade deficit has narrowed, but the labour market is slowing, and unemployment is rising.
• Political uncertainty is increasing, with a potential confidence vote against Prime Minister Trudeau’s government.
• The Canadian dollar remains resilient, performing well against other G10 currencies in a strong US dollar environment.

Europe

ECB Rate Cut Speculation Gains Momentum

Last week’s CPI data bolstered expectations of another rate cut by the European Central Bank (ECB) later this month, following the September reduction. The only significant upcoming economic data is August retail sales, which typically don’t move markets. Eurozone retail sales have been flat on average this year, much like the January-July period in 2023.

German Economy Facing Potential Contraction

German factory orders and industrial output figures are due soon, but with the Bundesbank warning of a potential contraction in Q3 (after a 0.1% decline in Q2), weaker data may not come as a surprise. In contrast, France, Spain, and Italy saw a modest rise in industrial production in August. Trade figures from Germany and France suggest that the economic shock from Russia’s invasion of Ukraine has been largely absorbed. The eurozone’s current account surplus is projected to be around 2.5% of GDP this year, a recovery from the -0.3% recorded in 2022.

Euro Weakness and Potential Targets

Stronger-than-expected US job data pushed the euro below $1.10, a key level that could see the euro fall to $1.08. While such a deep retracement seems possible, an initial target is more likely around $1.0900-$1.0910. After six consecutive days of losses, the euro may enter a consolidation phase, with resistance expected around the $1.10 level.

Key Points:

• CPI data supports the possibility of another ECB rate cut.
• German data may point to a slowing economy, while other eurozone countries show modest industrial growth.
• The euro has weakened and may test levels near $1.0900, with resistance around $1.10.

Japan

Japan’s New Prime Minister

Japan has formally appointed a new prime minister, Ishida, who is taking over an economy that shows signs of forward momentum and has successfully avoided deflation. The budget deficit is expected to decrease from approximately 5.5% of GDP this fiscal year to around 4.8% in the next. As a result, monetary policy is likely to gradually become less accommodative, with adjustments anticipated in interest rates and the Bank of Japan’s balance sheet. Speculation is growing that Ishida may call for early elections to secure his popular mandate.

Political Landscape

The main opposition party, the Constitutional Democratic Party, has chosen a former LDP official, Noda, to lead the charge in the upcoming elections. Noda is viewed as a skilled debater, potentially providing a formidable challenge to Ishida. Japan is set to release reports on labour earnings and household spending. Labour earnings have increased by 3.4% through July, but household spending has only risen by 0.1%. When adjusted for inflation, labour earnings show a slight increase of 0.4%. The June and July gains marked the first increases in over two years, yet Japanese households maintain a high savings rate and a low propensity to consume.

Trade Dynamics and Investment Trends

Japan runs a current account surplus alongside a trade deficit, and typically, both figures worsen in August. The current account report will also include details on portfolio flows by country. Recently, Japanese investors have been significant buyers of foreign bonds, while their investment in foreign equities has been more modest. Conversely, foreign investors have been net buyers of Japanese bonds over the past two months but have sold off Japanese equities.

Currency Movements

The US 10-year yield surged following a stronger-than-expected jobs report, pushing the greenback to JPY149, its highest level since mid-August. This bottoming pattern suggests a potential rise toward JPY150-JPY151. Discussions around new yen carry trades are emerging, but the typical characteristics of a funding currency include low volatility, which, along with low interest rates, is currently reflected in the three-month implied yen volatility, nearing 11.8%—the highest among the G10 currencies.

Key Points:

• Japan’s new prime minister, Ishida, faces a slowly improving economy and political challenges from a skilled opposition leader.
• Labour earnings are rising, but household spending remains stagnant, indicating a cautious consumer sentiment.
• Japanese investors are actively buying foreign bonds while foreign investors show mixed interest in Japanese assets.
• The US dollar has strengthened against the yen, raising prospects for yen carry trades amidst heightened volatility.

United Kingdom

Bank of England’s Patience Tested by GDP Data

The Bank of England’s patience will face scrutiny with the release of the August GDP figures, as the UK economy stagnated in June and July. Since the end of Q1, the monthly GDP has only risen once, in May. Industrial production remained nearly flat in Q2, followed by a 0.8% decline in July, primarily driven by a 1% contraction in manufacturing output. While construction showed a modest increase of 1.2% in Q2, it fell by 0.4% in July. On a positive note, the services sector has steadily increased by approximately 0.1% per month. However, net exports have been a continued drag on economic growth.

Upcoming Reports and Rate Cut Speculations

It is essential to note that the monthly GDP report is less impactful compared to the upcoming employment report (October 15) and CPI figures (October 16). The immediate concern is not so much about a potential cut next month—this seems assured—but whether there will be another cut in December. The UK currently offers the highest yields among the G7 countries, with its two-year yield briefly reaching nearly a 40 basis point premium over the US. However, this premium has since reverted to around 25 basis points. Additionally, the UK’s two-year yield premium over Germany surged from just below 120 basis points in mid-August to approximately 190 basis points now, partly explaining sterling’s recent outperformance.

Sterling Faces Pressure Amid Rate Speculation

Despite the favourable yield dynamics, the sterling had a challenging week. Comments from Bank of England Governor Bailey indicating a potential acceleration in the pace of easing, coupled with rising US interest rates, led to a 2.2% decline in sterling—the steepest weekly drop since February 2023. The currency fell from $1.3375 at Monday’s close to $1.3070 following the US employment report. Currently, sterling support is observed in the $1.3000-$1.3050 range and a convincing break below this area could trigger an additional two-cent decline.

Key Points:

• The UK economy shows stagnation, with only one monthly GDP increase since Q1.
• Focus shifts to upcoming employment and CPI reports, rather than immediate cuts.
• The UK offers attractive yields, but sterling faces pressure from rate speculation.
• Sterling dropped 2.2% last week, with potential support levels between $1.3000-$1.3050.