US Data Backs Up July Hike – But Key Data Still To Come

The US dollar showed strength last Friday and has since stabilized. The release of better-than-expected data from the US contributed to a significant 15 basis point increase in the 2-year US Treasury note yield. This movement marked the largest one-day change since the robust Non-Farm Payrolls (NFP) report at the beginning of June. The revised Q1 GDP data also exceeded expectations, with personal consumption driving the growth. I’m yet to determine the specific areas of revision in the data. Most of the strength in Q1 consumer spending occurred in January, but if the revisions extend to March data, it could raise expectations for Q2 consumer spending. Additionally, the increase in the dollar's buying was likely influenced by initial claims data, given the market's heightened sensitivity to labor market indicators, which have been a key driver of ongoing economic strength.

As I previously indicated in the FX Weekly report last Friday, the FX and interest rate markets will increasingly be influenced by incoming economic data as we approach the peak of tightening cycles. For the Federal Reserve, Friday’s Personal Consumption Expenditures (PCE) inflation data was a crucial piece of information. The average annualized increase over the past three months remains high at 4.92%, but it has decreased from 5.13% in March. It is important for this measure to continue decelerating to indicate a shift in momentum. Given that most other inflation measures in the US are now declining, there is an increasing risk that this underlying inflation measure will also begin to fall.

A stronger inflation reading would undoubtedly further raise the likelihood of a 25 basis point interest rate hike on July 26th. However, with the Non-Farm Payrolls report scheduled for this coming week, I do not anticipate a significant shift in rate hike expectations. Currently, the market has priced in an approximately 85% probability of a 25 basis point hike, leaving limited room for yields to fully reflect this expectation. The impact on the FX market is also likely to be limited, considering that last Thursday German inflation data showed a rebound in the harmonized rate from 6.3% YoY to 6.8%.

The performance of the US dollar is expected to remain mixed, consistent with its performance in the first half of the year. The dollar has strengthened against five G10 currencies while weakening against four. The British pound continues to be the top performer, although this partly reflects its poor performance in 2022. The yen has been the worst performing currency this year, with the Bank of Japan (BoJ) currently maintaining the most accommodative official policy rate in real terms. Only the Riksbank has a more negative policy rate, making the Swedish krona the third worst performing G10 currency. In the near term, there are potential downsides for EUR/USD, but an active European Central Bank (ECB) and higher core inflation throughout the summer should provide support. So far this year, the Euro has been the fourth best performing G10 currency.

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