Markets in celebratory mood as the doves aren’t crying anymore

The next head of the ECB could be former French finance minister and IMF head Christine Lagarde, if she is ratified by the EU Parliament. However, the markets are already jumping on the bandwagon and pumping their fists with joy as the ECB with Lagarde as its President would likely mean more of the same dovish path laid out by Mario Draghi. Financial markets don’t expect a rate hike from the ECB for the next 5 years. For now, this means higher stock markets, a slightly weaker euro and lower bond yields; this news pushed German bond yields to a fresh record low. 

The pound prices in UK economic stagnation

The market also expects the Bank of England to join the dovish brigade of major central banks, with a 50% chance now priced in that the BOE will cut interest rates later this year. The repricing of UK interest rate expectations has been driven by two factors: 1, both candidates to be the new PM are now touting the prospect of a no-deal Brexit as a potential possibility, which we highlighted on Sunday as kryptonite for the pound, and 2, the latest round of PMI data or June suggest that the UK economy is struggling and could have contracted last quarter.  This has weighed heavily on the pound, which has fallen back towards the lows of the year, key support now lies at 1.2510.  Below here opens the way towards $1.20 in GBP/USD, along with a major technical bias to the downside. 

Could better US data knock Fed rate cut expectations? 

The key central bank in this equation is the Federal Reserve. The market is fully expecting a rate cut at the Fed meeting on 31stJuly. However, there has been a subtle shift in expectations, with a 72.4% chance of a 25 -basis point rate cut, and a 27.6% chance of a 50-basis point cut. The prospect of a 50-basis point cut has fallen slightly this week from above 30% at the end of last week. The main driver of the slightly less dovish expectations for this month’s Fed meeting comes from the economic data released so far this week. Although private sector payrolls were weaker than expected at 102k vs. 140k, they have picked up from May. The ISM manufacturing index also beat expectations for June, business sentiment has picked up and jobless claims were slightly lower. All of this suggest that the US economy, although weaker than it was, may not need a 50-basis point interest rate cut to get back on its feet. 

UK remains the weakest link 

A basic analysis of economic data released so far this week, suggests that the UK is the weakest out of the major economies. The manufacturing sector is slipping deeper into contraction territory, while the service sector PMI survey for June suggests that the service sector of the economy is just about managing to expand. Mortgage approvals and consumer credit are all contracting, and house prices continue to fall. In contrast, the EU composite PMI for June beat expectations, rising to 52.2 compared with 51.8 in May. As explained above, the US economy has also surprised to the upside. This suggests that the pound could be the laggard vs. the USD and the EUR for the short-term as we wait for the important US labour market data that is released this Friday. 

FX: a short-term trading guide 

Worth noting is the relative performance of the world’s developed market economies. Using the Citi economic surprise index as a guide, Canada is seeing the strongest positive surprises, followed by Japan, Sweden, Norway, Australia and New Zealand (that is one reason why the RBNZ decided to stay neutral at its last meeting, sending the Kiwi dollar higher). In contrast, the US, UK and BRIC economies have experienced the largest negative surprises in their data releases. The most basic way to interpret this data is that the economies with the most positive surprises should see their currencies rise, while those with the highest number of negative surprises should see their currencies fall and based on this analysis traders may want to short USD/CAD or GBP/SEK. However, a contrarian investor may decide to do the opposite, seeing USD/CAD as ripe for a recovery after experiencing a move from 1.35 down to 1.3075 since the start of June. Likewise, some investors may believe that the SEK is too stretched to the upside, after GBP/SEK fell from a high of 12.60 in early May to 11.71 today. We believe that the pound’s ability to recover remains constrained by Brexit, however, if we get a strong payrolls report on Friday then a USD recovery could become a possibility, particularly vs. the Cad. 

Talking payrolls 

Happy Independence Day to all of our American readers! Once the last firework has exploded the focus will shift to the all-important US payrolls report for June, this is the last labour market report before the Fed meeting at the end of this month, and it could be critical to determining the Fed’s next move. The market is expecting an increase of 160k jobs for June, up from the dismal 75k for May. The unemployment rate is expected to remain at 3.6%, while wage growth is expected to rise by 0.3% for the month, compared with 0.2% in May. Unless we get a big surprise in the unemployment rate or wage growth data, which we don’t expect, then the focus is likely to remain on the headline NFP figure. The question traders want to know: was May’s weak data a blip, or is it the start of a trend? 

While it’s always difficult to predict the NFP number, some key NFP leading indicators are worth watching to see if they can give us a hint about what to expect. So far, the positive indicators include: the employment component of the ISM non-manufacturing index, job openings, and Challenger jobs cuts. Initial jobless claims and consumer confidence remain neutral for payrolls, the weaker ADP report for June and the previous payrolls report for May are often correlated with the NFP number and are negative for Friday’s release. Please note that at the time of writing the ISM non-manufacturing survey had not been released. On balance, the outlook for this week’s NFO report remains neutral for now, which suggests that the NFP may be come in around expectations at 160k. Due to the very weak NFP reading for May, a June reading around expectations could ease fears that the US labour market is in trouble, which may be dollar positive at the end of this week. Whereas, a second month of weak NFP data could see the dollar tumble, and stocks rise, as expectations of a 50-basis point interest rate cut from the Fed would likely gain traction. USD/JPY is historically sensitive to the NFP report, and as mentioned above, USD/CAD is also one to watch around this data release.