Core PCE Deflator May Challenge Greenback’s Firmer Tone

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  • The US dollar recovery was marginally extended in Asia, and while it remains firm, it has lost some of its momentum  
  • China’s August manufacturing PMI rose to 51.7 from 51.4 
  • The ECB meeting next week is important 
  • Bank of Korea kept rates steady at 1.25%, as expected; Poland reports August CPI; Colombia’s central bank is expected to cut rates 25 bp 

The dollar is mostly firmer against the majors, extending this week’s recovery. The Loonie and Aussie are outperforming, while Kiwi and sterling are underperforming. EM currencies are softer. RUB and INR are outperforming, while TRY and MXN are underperforming. MSCI Asia Pacific was up 0.1%, with the Nikkei rising 0.7%. MSCI EM is down 0.2%, with the Shanghai Composite falling 0.1%. Euro Stoxx 600 is up 0.7% near midday, while S&P futures are pointing to a higher open. The 10-year US yield is up 2 bp at 2.15%. Commodity prices are mixed, with oil up 0.3%, copper up 1%, and gold down 0.2%.

The US dollar recovery was marginally extended in Asia, and while it remains firm, it has lost some of its momentum. The Fed’s target inflation measure (the core PCE deflator) may decline from 1.5% to 1.4%, according to the median forecast in the Bloomberg survey. That would be the lowest reading since the end of 2015 and could likely spur more speculation against another Fed hike before the end of the year.

Bloomberg currently calculates the odds of a hike by the end of the year to be near 33%, while the CME model puts the odds at closer to 40%. We think the odds are somewhat greater, though not because of any special insight into the path of core inflation. Rather, we put more emphasis on the Fed’s third mandate of financial stability, which we feel the market does not appreciate sufficiently.

Specifically, we underscore the July FOMC minutes that showed that official concern about asset prices had been ratcheted up. We have noted that in several speeches, the Fed’s leadership and some regional presidents have made references to financial conditions. The Fed judges that the economy requires less accommodation, and so it removes some through three increases in the Fed funds target in the past year. The market has countered this, and financial conditions remain by some measures more accommodative than before the Fed’s recent hikes. We do not think the Fed is simply going to capitulate to market forces.

Indeed, the Fed’s confidence in the US economy may be bolstered by yesterday’s news that included the upward revision to Q2 growth, led by consumption and business investment. The 3% annualized pace is the fastest in two years. Elsewhere, the ADP jobs estimate was the best in five months.

Previously, the Fed had been concerned about the global headwinds. The pendulum of market sentiment has swung from “How can the Fed be the only one normalizing policy?” to “Other countries are moving away from unorthodox policies, while the Fed may be too hawkish.” The world’s second largest economy has also surprised many observers in its resilience, though we did not expect anything else in this important year for China’s politics.

China’s August manufacturing PMI rose to 51.7 from 51.4. This is the second highest this year. Gains were recorded in production, new orders, and imports. On the other hand, the expansion in the non-manufacturing sector slowed to 53.4 from 54.5. It is the lowest since May 2016. This is something that needs to be watched, though it may prove to weather-related, according to some reports. Caixin reports its August manufacturing PMI tonight, which is expected at 51.0 vs. 51.1 in July.

Yesterday, Germany and Spain reported somewhat higher than expected preliminary August CPI. This warned of a higher regional reading today and sure enough, EMU CPI rose to 1.5% y/y from 1.3% in July. The median forecast was for 1.4%. The core rate remained unchanged at 1.2% for the second month. It matches the high from earlier this year and the highest level since early 2013. Separately, Eurostat reported that the unemployment rate was unchanged in July at 9.1%. The last cyclical trough (2007) it was at 7.3%.

The ECB meeting next week is important. The ECB is expected to announce an extension of its asset purchases but at a slower rate (tapering). Many expect that Draghi may seek to put a dovish spin on it to prevent the markets from prematurely taking away the proverbial punch bowl. We do not think that today’s inflation report changes the ECB’s assessment of the underlying path of inflation, which they find wanting.

At the start of the month, the weakness of the dollar-bloc currencies and sterling gave hints that the US dollar’s downtrend was moderating and consolidative forces took hold. The Australian and Canadian dollar’s price action warned of a new set back from the US dollar. The US dollar is bouncing off support seen near CAD1.24, the low set in late July. Today will likely provide a test of it. The US dollar pushed a little through CAD!.2650 earlier today, which is a 61.8% retracement of its decline since mid-August.

Canada reports Q2 GDP today. A strong showing is expected, with growth seen at 3.7% annualized, unchanged from Q1 and the second consecutive quarter that the y/y pace is above 4%. This could see the Canadian dollar strengthen on what would be seen as additional confirmation of a follow-up rate hike in October.

The Aussie was turned back from $0.8000 yesterday, and it posted a potential key reversal by making new 3-4 week highs and then selling off and closed a smidgen below the previous day’s low. There has been a little more follow-through selling today. A break of $0.7850 signals a return to the $0.7800 area seen in the middle of the month and mid-July.

Sterling is trading heavily, after closing the North American session near its session highs. It has slipped through yesterday’s lows, which corresponded to a 50% retracement of sterling’s bounce from $1.2775 last week to nearly $1.2980 this week. The next retracement level is seen near $1.2850. As we recently suggested, the EU negotiators are not satisfied with the UK’s effort on Brexit to date, and this makes the EU unlikely to signal that it is ready to discuss the post-Brexit relationship. The UK government’s reported hopes to pull an end run and appeal directly to Merkel and Macron is unlikely to prove successful. It is far too early for the heads of state to overrule the EU’s negotiating team.

The euro is in less than a half cent range. It has extended its pullback for the third day but has stabilized around little-changed levels. The euro has not recorded a three-day fall since early July. There are two option strikes that are in play today. There are 726 mln euros struck at $1.1875 and another 642 mln euros struck at $1.19 that expire today. The $1.1865 area represents the 50% retracement of the latest leg up in the euro that we see beginning on August 17 near $1.1660. The 61.8% retracement is near $1.1820.

The dollar is trading higher against the yen. It had reached almost JPY110.65 after posting a key reversal on Tuesday, when the JPY108 level held. The JPY110.65 area is the 38.2% retracement objective of the dollar’s drop since testing JPY114.50 on July 11. In the middle of this month, the JPY111 level held back the dollar’s recovery attempt.

Bank of Korea kept rates steady at 1.25%, as expected. CPI rose 2.2% y/y in July, close to the 2% target. July CPI will be reported Friday and inflation is expected to remain steady at 2.2% y/y. The bank noted the outlook remains uncertain due to Pyongyang’s missile tests. With growth concerns still present, the central bank is likely to remain on hold for now. Prior to the BOK decision, Korea reported July IP rising 0.1% y/y vs. a revised-0.5% (was -0.3%) in June.

Poland reports August CPI, which is expected to rise 1.8% y/y vs. 1.7% y/y in July. If so, this would still be below the 2.5% target but within the 1.5-3.5% target range. The next central bank policy meeting is September 6, and it is expected to keep rates steady at 1.5%. With price pressures remaining low, the bank is unlikely to hike rates in 2017.

Colombia’s central bank is expected to cut rates 25 bp to 5.25%. The bank has cut six meetings in a row, for a total of 200 bp. CPI rose 3.4% y/y in July, the lowest since October 2014. While still above the 3% target, the poor growth outlook has led the central bank to continue its easing cycle.