China cuts USD bearish

USD soft after China rate cut.

The USD is weaker this morning following China stimulus and expectations for decelerating US inflation while the decline of the USD aligns with my medium-term prediction, I remain unconvinced. The market's rationale is that slowing inflation will curb the Federal Reserve's inclination to raise interest rates and potentially lead to rate reductions. Presently, the market has factored in the likelihood of a 25-basis point rate cut by the end of the year, which would reverse the previously expected 25 basis point hike in July. Yesterday CPI data for May came lower than expected (that have been broken down here by me on Business Today; https://www.businesstoday.com.my/2023/06/14/is-a-lower-cpi-enough-for-the-fed-to-pause/ ), indicating a deceleration in year-on-year (YoY) rates for both overall and underlying inflation, seems to support this argument. However, the issue lies in the projection that core CPI will still settle at 5.2% YoY, accompanied by a significant 0.4% month-on-month (MoM) increase. The Federal Reserve's current forecast for the core Personal Consumption Expenditures (PCE) deflator is that it will reach 3.6% in the fourth quarter of 2023. In April, the reading was 4.7%, with an average monthly change of 0.40%. Economists from HSBC emphasize that the data for the remainder of the year would need to maintain an average monthly change of 0.23% MoM to align with the Federal Reserve's forecast. Consequently, a 0.4% MoM increase in core CPI in today's report would not be particularly accommodative or advantageous for the Federal Reserve.

GBPUSD is higher this morning after a hawkish labour report, but steady EURGBP suggests some ambiguity around the GBP reaction in April, the unemployment rate defied market expectations by dropping to 3.8%, contrary to the anticipated rise from 3.9% to 4.0%. What's even more noteworthy is the robust growth of average weekly earnings, which recorded a YoY increase of 7.2% for the three months leading up to April, surpassing the consensus forecast of 6.9%. As a result, market sentiment towards the Bank of England (BOE) has become more hawkish. Swap markets are currently pricing in a 31 basis points increase for the June meeting and a total of 125 basis points by the end of the year.

The strengthening of the GBP-USD exchange rate aligns with this hawkish shift in expectations for the BOE. However, it is interesting to note that the EUR-GBP exchange rate has not decreased as one would expect if the GBP's strength was the driving force. This lack of GBP outperformance might indicate uncertainty about whether a more aggressive BOE stance is beneficial for the currency, considering the potential negative impact on economic growth. The battle between carry support and recession risks has reached a stalemate, as reflected by the steady performance of the EUR-GBP exchange rate.

Therefore, the upward movement in GBP-USD can be attributed to the weakness of the USD, influenced by expectations of US inflation and stimulus measures implemented by China (as mentioned earlier).

The EUR is higher against a retreating USD, with a mixed German ZEW index not really offering clarity in June, the current situation balance witnessed a significant decline, dropping from -35.8 to -56.5 (consensus was -40.2). This decline aligns with the recent weakness observed in manufacturing surveys, further confirming the reality of an economy experiencing a technical recession. However, the overall negative sentiment was offset by a slight improvement in the expectations component, which improved from -10.7 to -8.5 (consensus was -13.5). This improvement could be attributed to the robust performance of the service sector surveys.

Upon analysing the sector breakdown, it became evident that certain industries such as autos and mechanical engineering experienced deteriorating readings. Conversely, there were gains observed for banks, services, and insurance companies. Another contributing factor to the positive expectations component might be the ongoing rally in the local equity market, which is nearing its historical highs once again.

The ZEW institute interpreted the survey as an indication that while improvement is not expected, the downturn is also not a cause for alarm.

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