USD: US yields continue to fall after US PPI report

The US dollar has continued to trade on a softer footing this week encouraged by the scaling back of Fed rate hike expectations. The 2-year US Treasury yield fell to a low yesterday ta 4.12% moving further below the high recorded earlier this week at 4.26%. Market participants have become less confident that the Fed will hike rates in response to the energy price shock. There are currently around 8bps of hikes priced in for the September FOMC meeting compared to around 14bps prior to the release of last week’s nonfarm payrolls report for July. The slowdown in private employment and wage growth in recent months alongside limited evidence of higher energy prices spilling over into core inflation since the US-Iran conflict started is providing more leeway for the Fed to leave rates on hold. The dovish repricing of Fed rate hike expectations continued yesterday even though the components of the PPI report that feed into calculating the PCE deflator were more lively than expected. There was a 5.6% jump in PPI portfolio management prices that will boost the core PCE deflator in July. However, the BEA has already stated that it is revising its methodology for calculating PCE portfolio management prices as well as software and legal services prices on 30^th September. The revisions are expected to subtract at least 0.2ppts from the current rate of core PCE inflation. As a result, the Fed is likely to place less weight on the upside inflation surprise in July. The US rate market has looked through yesterday’s PPI report and continued to pare back Fed rate hike expectations.

The ongoing decline in short-term US rates has been providing a headwind for the US dollar performance this month but has not yet been sufficient to trigger another leg lower after the sell-off at the end of last month. The dollar index continues to trade above support from the 200-day moving average at around 99.200. The price action suggests that the US dollar could be deriving support from inflows into the US equity market in particular AI-related stocks (click here). US tech stocks have outperformed so far this month with the Nasdaq equity index rising by 5.5%. At the same time, the S&P 500 index has risen to fresh record highs above 7,800. It has been another blowout quarter of US corporate earnings in Q2. Blended (year-over-year) earnings growth for the S&P 500 companies has been around 50% which would mark the highest earnings growth rate since Q2 2021. Factset noted that in aggregate companies have reported earnings that are around 29% above estimates which is above the 5-year average of 5%. The unusually high earnings surprise percentage is mainly due the unusually large positive EPS surprises reported by Alphabet and Amazon. After excluding Alphabet and amazon, the earnings surprise percentage drops to around 11%.

EUR/GBP VS. CARRY ATTRACTIVENESS OF GBP

Source: MUFG Research, Macrobond, Bloomberg

GBP: UK economy and pound are proving resilient to energy price shock

The pound is continuing to perform well this year. It has been the best performing major currency so far in August with cable rising back above the 1.3500. The pound has been supported by further evidence yesterday that the UK economy is proving more resilient than expected to the negative energy price shock triggered by the US-Iran conflict. It was revealed yesterday that the UK economy expanded by 0.4% in Q2 following strong growth of 0.6% in Q1. The breakdown revealed that growth in Q2 was driven stronger than expected private consumption growth (0.3%) and business investment (1.7%). After stagnating following the Brexit vote in 2016 until the COVID shock in 2020, business investment has since regained upward momentum providing a tailwind for the UK economy. It has increased by around 13% since Q4 2019. The monthly GDP figures provided further encouragement that growth momentum will continue in Q3 after growth picked up in June. Stronger service sector growth (+0.5% 3M/3M) was supported by the IT sector (+2.7% 3M/3M) indicating a boost from AI-related demand.

The next focus for market participants will be the release next week of the latest UK labour market and CPI reports. The soft labour market and recent downside inflation surprises have eased pressure on the BoE to hike rates in response to the energy price shock even as the UK economy has held up better than expected. The Uk rate market has pushed back the timing of a BoE hike until the end of this year. However, the pound has failed to weaken as yield spreads have moved against it suggesting stronger growth and still favourable carry conditions remain supportive.