Rates as of 05:45 GMT


• Buy DXY index:  I think the dollar’s decline is way overdone. Bullard doesn’t represent a consensus on the FOMC. The market is pricing in far too many cuts in US rates.
 Sell EUR/USD:  I expect dollar strength today to be particularly noticeable in EUR/USD
• Sell USD/GBP:  Fears about the UK economy are likely to intensify after yesterday’s disappointing UK manufacturing PMI.


Market Recap

The dollar plunged after St. Louis Fed President Bullard said the Fed might need to cut interest rates soon. This was the first time since they put rates on hold earlier this year. Fed official had specifically said a cut might be necessary “A downward policy rate adjustment may be warranted soon to help re-center inflation and inflation expectations at the 2% target and also to provide some insurance in case of a sharper-than-expected slowdown," Bullard said.

His pessimistic comments about the impact of the trade talks on the global economy also had an impact on markets. “Recent developments in global trade negotiations suggest that it may be more difficult to reach a stable global trade regime than previously thought. This is likely to chill global investment and feed into slower global growth. The direct effects of trade restrictions on the U.S. economy are relatively small, but the effects through global financial markets may be larger.”

Bullard, known to be one of the more dovish FOMC members, is a voter this year so his comments are of more than passing interest. His comments sent Fed funds futures soaring (i.e., pricing in more of a cut). At yesterday’s close, the market was expecting 60 bps of cuts this year, vs 48 bps on Friday.

That’s quite different from what the median Fed official is looking for, as far as we know. At the March FOMC meeting, no one was looking for lower rates this year, and indeed the median was looking for a hike next year, according to the famous “dot plot.” The next FOMC meeting, June 18-19th, will include an update of the dot plot.

The market thinks differently however. As you can see, there’s a big gap between the dot plot estimates and the market estimates (derived from the Fed funds futures market) for what rates will be at the end of each year.

As for the need “to help re-center inflation and inflation expectations at target,” the 15% decline in oil prices over the last two weeks is one of the main reasons why the market expects inflation to fall below the Fed’s 2% target. The Fed of course can’t target oil prices specifically, but they are to some degree a function of economic activity, which the Fed can help or hinder.

Fed Chair Powell will discuss monetary policy strategy, tools and communications practices at the Fed’s framework review conference today. The text of his statement will be published. He might make some comments about this issue, which could prove important for the market. If he does, I’d expect him to repeat the usual comments about being “patient” rather than moving to cut soon. That would tend to be positive for the dollar.

The pound fell after the UK manufacturing PMI unexpectedly fell below the 50 “boom or bust” line. The 3.7-point fall was the biggest since the Brexit referendum and indeeed this was the first time since then that the PMI has been below 50.

The Reserve Bank of Australia (RBA) cut rates this morning, as expected. That’s not the end of it, though. The market now sees a cut at the July meeting as a 100% probability! That’s probably because the RBA statement said that labor market conditions “suggest that the Australian economy can sustain a lower rate of unemployment.” It then finished up by saying “The Board will continue to monitor developments in the labour market closely and adjust monetary policy to support sustainable growth in the economy and the achievement of the inflation target over time.” In other words, so long as the unemployment rate is above what they think the non-accelerating inflation rate of unemployment (NAIRU) is, they’ll keep lowering rates. (NAIRU is the lowest level of unemployment that the economy can achieve without inflation speeding up.)

So why did the AUD strengthen? It could be just “sell the rumor, buy the fact” even though longer-term it’s AUD negative. But I think this time it had less to do with the RBA and more to do with the FOMC. That is, the big lurch upwards in AUD/USD came when Bullard was talking. Looking at the three-month interest rate futures, we can see that despite the cut in rates in Australia, the expected spread of Australian rates vs US rates is expected to narrow in Australia’s favor over the coming months, and expected to narrow more than it was just a week ago. That’s the power of expectations.

Personally, I disagree – I don’t think Bullard represents a consensus on the FOMC and I think the market is getting wildly ahead of itself – expecting a rate cut just because the S&P 500 is down 6.8% from its April peak. I expect Powell to reiterate his “patient” theme, I expect the upcoming FOMC meeting to be much less dovish than the market, and for the dollar to rebound.

Today’s market

The day starts with the UK construction PMI. After yesterday’s disastrous manufacturing PMI, this may take on more significance. The two don’t always move together; since 2013 they’ve only moved in the same direction 53% of the time, basically random. So it is possible that the construction PMI is more or less unchanged, as the market expects. Still, it would surprise me, given the slowdown in investment and in mortgages in the UK.

EU inflation is expected to slow noticably. This would be in line with what we saw for German inflation during the same month:  the headline rate of inflation plunged from 2.1% yoy to 1.3% yoy. German core inflation remained at 2.0% however, suggesting that a lot of fall was due to lower oil prices. For the EU-wide figure however core inflation is also expected to slow, to 0.9% yoy from 1.3%.

Back in April, ECB President Draghi said he expected headline inflation to slow because of falling oil prices, which is fair enough. With regards to core inflation though he said:

Measures of underlying inflation remain generally muted, but labour cost pressures have strengthened and broadened amid high levels of capacity utilisation and tightening labour markets. Looking ahead, underlying inflation is expected to increase over the medium term, supported by our monetary policy measures, the ongoing economic expansion and rising wage growth.

I wonder how long “the medium term” is and whether a downturn now will affect the ECB’s medium-term outlook. We’ll know more about that after the ECB meeting Thursday. EUR negative

US factory orders are expected to be down in a reaction to the previous month’s sharp rise. Given that durable goods were down 2.1% mom, a 1.0% decline in factory orders for the same month probably wouldn’t come as any surprise. USD neutral

Australia’s GDP is expected to rise at a faster qoq pace, but to continue to slow on a yoy basis. The slowdown is centered on housing and consumption as banks tighten their lending conditions and wage growth remains sluggish. However, higher government spending may provide some life in Q1. My guess is that with the market already convinced that the Reserve Bank of Australia (RBA) is going to cut rates again this year, slower yoy growth will only add to that conviction and should prove negative for AUD.


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Marshall Gittler

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