Fed rate cut expectations have gone too far

Okay, morning guys, hope you're all well. So, 10th of June, let's see, start of a new week, and we've got some moves across markets this morning, just sort of digesting the developments over the weekend. Perhaps the key one being that Trump has seemingly done some kind of deal with Mexico, so we're going to talk about that. But let's perhaps, before we go any further, just have a look at that week ahead, and we'll talk about the key items here that we know are going to happen. So these are all the scheduled events, mostly by way of economic data. So I'll have a quick look through here before then, just thinking about last week. We definitely had a big, big week last week. Most of it centered around the idea that the Fed are going to accelerate their rate-cutting cycle, or they're going to begin it and then it's going to accelerate faster than expected. More bad data from the, the US on Friday with the non-farm payrolls disappointing. But if we look at the week ahead, I mean, we've already had some Japanese GDP data this morning that slightly beat expectations. So 0.5— sorry, 0.6% growth rather than 0.5 expected. We've had some Chinese trade balance figures. The import data disappointed, dropping over 8% on a year-on-year basis. But other than that, I mean, today is quite quiet, um, from a data point of view. We have some bank holidays going on in Europe, but also normally the Monday after Non-Farm Payrolls Friday is a pretty quiet affair when it comes to economic data being announced. So today will probably— well, certainly from a scheduled news flow point of view, um, won't be too interesting, I wouldn't say. Um, tomorrow, just looking at some of the other facts, I mean, you've got Japanese-US kind of trade talks going on through the week, by the way. Um, not expecting too much from that other than potential risk for Trump to throw in some more spanners into the works, but we'll see. But we've got some wage growth and, well, just generally the labor market report from the UK on Tuesday. Again, nothing massive from the US, I wouldn't say, in terms of key data points. So we move into Wednesday, and this certainly becomes the biggest day of the week from an economic data point of view, in my opinion. And there's something underlined there, and it's going to happen at 1:30 PM on Wednesday, and it's called US CPI. This is the absolute big one of the whole week. I'll review it in a second, but last week was a monster week for assets like equities, assets like gold, assets like bonds rising rapidly off the back of the Fed turning a lot more dovish. Now, the only way the Fed are going to be able to start cutting rates is if inflation starts to tick down, starts to tick lower. And Wednesday's reading, which will give us the inflation readings for the month of May is absolutely critical. And this will be the first item on the agenda since the payrolls data last week. This will be the big item that really tells us, can the Fed start cutting in July or not? And as I'll go on to show you, um, analysts are now thinking there are going to be 3 rate cuts in 2019. We're almost halfway through the year. As Ant was saying on Twitter over the weekend, I, I just I think it's too aggressive. I think the analysts have now overextended their expectations towards rate cuts, but we'll see because that inflation data on Wednesday is absolutely pivotal for that. Thursday dominated by— well, will be dominated by UK politics, or certainly here in the UK it'll all be about the first round of ballots for Conservative leadership. So we'll talk about this during the briefing, Boris and Gov having to fight off cocaine-taking accusations— well, not accusations, evidence in his youth— which has kind of derailed his campaign somewhat. So we'll talk about that. And then Friday, the key kind of news here, again underlying— we've got some Chinese data of interest with industrial production, but retail sales coming out of the US will be another big one. But for me Um, all eyes on the US CPI data at 1:30 PM on Wednesday, and will that alter the current market's expectations with regards to how quickly the Fed are going to start cutting rates? If you're just getting to your desks, 5 things you need to know to start the day, and the first one, um, happened over the weekend. And, and if I just flick back to the charts, this is about Trump and Mexico. Flip back to the chart. Let's have a look at the Mexican peso, actually, because it's rallied quite strongly. You can see this gap higher here on the Mexican peso. I'll just draw a rectangle there. Big jump higher. So the market opened a lot higher this morning to get the week going. And if I draw a line there, we just kind of jumped back up above this low point that we had on the 29th of May. And so the peso, I guess the next target would be be this one here, which is that top that we had on, on the 30th of May. So the peso nice and strong. And this is off news that a deal, a deal has been done between Trump and the Mexicans, some kind of— not much detail, it must be said, but some kind of deal where they'll be involving agricultural commodities, and then i.e. Mexico buying more agricultural commodities from the US, and in exchange, um, they're going to stem the immigration situation. Although what I would say is, um, the Mexicans have been, uh, less forthcoming with their sort of, um, confirmation that this deal has happened. Some of the sources over in Mexico are saying, oh, I'm not sure what the agricultural deal is all about. But anyway, Trump has his headline and markets have moved. And it does, you know, with this whole global trade war risk involving Donald Trump, obviously you go through your ebbs and flows and we're at the whim of the man and his Twitter feed. But it does seem that we've got continued positive direction with regards to some kind of resolution with the Mexican situation. You can't say that about the Chinese situation, which still remains unresolved for sure. So that's definitely still a risk on the table. But we have a slight positive this morning that's kind of feeding into market sentiment. And so the peso is the one leading the charge to the upside. If you have a look at other markets, let's just bring out the S&P chart here and make that a bit bigger. You've seen a bit of a gap open, but the market was unable to sustain that gap. I'll draw another rectangle in there. Which shows you where the market closed on Friday, and then we jumped up and opened above Friday's high this morning, or I should say overnight, but then we've drifted back lower and been a bit of a flat line. I'm going to draw a line here, a bit of a flat line with Friday's high still being that key resistance that's really shaped most of the session so far. So stocks tried to go higher but haven't really been able to add to last week's gains, which were sensational. And I'll come back to that point in a second, but just wanted to review the, the early movers this morning because gold's come under pressure. Uh, so here gold gapped lower. So here's the box, here's Friday's close, and gold gaps lower, opens lower, and then we've definitely continued and extended on those moves to the downside. And right now we're just trading down below the kind of break of this double bottom we had on the afternoon of the 5th and the, the morning of the 6th of May last week. Okay, so gold under pressure. So this is just a little bit of positive sentiment as a result of the US-Mexican trade deal of sorts. And so the safe haven markets of gold and the yen as well have come under pressure. So the yen's down on the day despite obviously that GDP data that beat expectations. Um, let's just have a quick look at that. So, uh, one second. Here's the, here's the yen against the dollar. And so we've gapped lower again, lots of gaps in the markets this morning. Um, let me just alter a couple of these lines. And for the yen, we've broken below Friday's low, and again, that's been quite a nice resistance ever since. So a slight risk-on tone Um, with regards to T-notes, um, another safe haven market, obviously. Let me go to a 60-minute chart. Another gap, uh, here as the market opens lower. But for T-notes, I'm really not— like, gold opened lower and extended lower. T-notes has not. T-notes opened lower and it's kind of been a bit of a chop fest around the low point that we had, um, on Friday, um, so, uh, well, that's Thursday, isn't it? Um, so yeah, Tino's yet to really extend lower, but certainly in the main, a general, uh, slight positive vibe. I mean, emphasis on the word slight, um, and really led by the Mexican peso. Um, so that's the situation with this morning's sentiment. Um, let me go back to my kind of headlines. And, you know, we'll talk about Boris, we'll talk about stocks. So, you know, let's, let's move on here and, and think about, um, other factors. And I want to talk about last week, and I want to talk about the Fed, and I want to talk about rate cut expectations. And we'll have a quick review of the, the kind of key data that we had on Friday that was disappointing. So just first up though, this is a look at the, some of the key global markets and how they performed last week. And just a quite sensational week for US equities. Check out the top of the list: Dow Jones, S&P 500, um, both climbing in excess of 4% across last week. Uh, MSCI World Equity Index also 4% to the good. Uh, the NASDAQ higher. Gold ramping higher over 3%. Um, Stoxx 600 up. Uh, so you can, you get the vibe here. Um, it's Basically stocks and gold, um, up through the roof. Um, TOPIX Japanese index, of course, Asia ex-Japan positive. So everything pretty positive apart from the dollar and crude oil. And crude oil particularly, um, getting some downside. We'll talk about crude in a minute because crude has turned and it's tried to climb higher this morning. It's, it's finding it hard work, but we'll talk about crude oil at the end. But I just wanted to put this on the table here to just show you how dramatic the movement has been last week. And why has this happened? Well, of course, it's mostly due to the fact that the Fed last week, at the start of the week, indicated— this was Jerome Powell's speech, uh, the Fed indicated, um, that, uh, the probability of a, a rate cut is climbing. The Fed have said that ultimately economic momentum in the US is dropping and that they're looking to perhaps, you know, start to behave in a way to be much more supportive and stimulative with their policy tools. So, um, let's look at the data on Friday that just added more fuel to that argument because we got much worse than expected non-farm payrolls data. So this is looking at how many jobs were created in the month of May, and it came in at 75,000, way below what we were expecting, which was 185,000. They also chopped the April reading, they revised that down, it was 263,000, they revised it down to 224,000. They also revised down March. Okay, so from a job creation point of view, um, the labor market report from the US on Friday was really bad. There's no getting away from that. One caveat, it wasn't quite as bad as the reading we had for February, which was down at 56,000, but nevertheless really bad. But as I was saying during, you know, in the prep for the data on Friday, you got to understand that really most economists, most investors, most traders aren't particularly focusing on job creation at this point in the economic cycle. And that's because the unemployment rate's at a 50-year low. The labor market is becoming tighter and tighter. And when you're getting towards, you know, late cycle, then generally speaking, you see a lot more volatility in job creation figures because, you know, the employment rate is so strong. So you shouldn't be particularly surprised by this, and you shouldn't be particularly surprised by the fact we're going to get more volatility in this dataset, the nonfarm payrolls data, as we go through the rest of the year. Okay, it's very much late cycle behavior. What's more interesting for me is the wage growth figures because ultimately, are the Fed— yes, okay, you know, headline data like payrolls really bad, um, you know, like the manufacturing ISM data bad, but are the Fed going to cut rates? Is the data bad enough is the key question. And ultimately, what will force the Fed's hand is the last bit of the jigsaw, is that inflation needs to now weaken. Okay, the only way inflation is going to weaken if wage growth stops happening. So what was supportive of rate cuts on Friday was actually the fact that the wage growth data— we're looking at the average hourly earnings here, and for the month of May, wage growth went up by 0.2%. Now, we had expected a 0.3% growth rate. So this was worse than expected, but it only just— I mean, it's in line with the last 3 months, okay? It's not like we're down at 0.1% or 0%. So you haven't seen a change of trend here. It just wasn't as high as expected, okay? Um, so how has that panned out, and how has that altered the expectation of the Fed cutting rates? So I'm looking at the CME CME Group website. This is quite a good— something called the CME FedWatch Tool. Most of you guys will know about this. This is looking at, well, at each meeting at the top here. The next meeting is coming on the 19th of June, and it's saying, well, what's the probability of where interest rates will be after that meeting? And at the moment, there's a 79.2% chance that interest rates stay unchanged. So currently the Fed's interest rate is between 2.25% and 2.5%, and we're not expecting a change despite all this weak data. The general school of thought is that June— the June meeting's too early, so most likely 79% chance rates stay unchanged. But when you move to the July meeting, so there's a meeting on the 31st of July, if we click on that button, we'll then look at how things shift Remember, currently rates are between 2.25% and 2.5%. Apparently now, according to market expectations, there's only a 19% chance that rates will stay unchanged by the July meeting. So it's now 66.3% chance that the Fed will cut rates at their end of July meeting. Okay, you got some wildly dovish predictions over here. 14.7% think there'll be a double rate cut of 50 basis points. 0.5%. Then we check September. Here's— this is important as well. The September probabilities now indicate 2 rate cuts, 2 rate cuts from the Fed by September's meeting. So the market consensus is the Fed cut once in their July meeting and cut again in their next meeting in September. Then we click on October. And here expectations are that no more rate cuts in October. We stick at 1.75% to 2% range. But then when you flick on December, we're just— actually, it has just changed. Okay, it literally has just changed in the last 30 minutes. Uh, 30 minutes ago we did have 1.5% to 1.75% just marginally edging out, um, 1.75 to 2. Basically, 30 minutes ago, it was an expectation that the Fed would cut 3 times this year. Now that has just marginally tweaked back, but you can see it's pretty even. The reason why it's marginally tweaked back is because of this Mexico trade deal, okay? Um, but the point is we're almost evens, neck and neck, for a 3 rate cuts this year versus a 2 rate cuts this year. Okay, this is one of the reasons why the S&P has not been able to rally above 2,900 off this Mexico news. It's because good news now on trade means less likelihood of the Fed cutting rates certainly 3 times. I mean, I thought 3 times was way overdoing it anyway, um, but the point is right now markets are expecting 1 cut in July, cut number 2 in September, and it's neck and neck for 3 cuts or stick at 2 for December. Okay, and these are the big influences that are moving markets. We've got a, we've got a good chart here to show you how quickly expectations have changed. This is how the probability— will there be 3 rate cuts in 2019? And the probability of this has ramped higher too high, too fast. You know, this is quite behavioral, I would say. Um, it's been below 10% all year. That's the chances of 3 rate cuts have been below 10% all year. We broke 10%, now we've gone up to 63%. So I believe this is a knee-jerk emotional behavioral reaction. I think at best you're looking at 2 cuts. Um, and so I would expect this probability to now soften and drop back lower unless the inflation data on Wednesday is lower than expected. So let's have a look at this inflation data on Wednesday. This is the current chart looking at inflation, headline inflation, over the last 12 months. Okay, now most of this behavior that you can see on this chart is perhaps related to crude oil, certainly the left-hand side where you saw inflation very high, summer of 2018, um, oil prices climbing. And then we had the big oil sell-off, and so oil led to inflation dropping to 1.5%. Now we've rebounded marginally here. Now we've rebounded to the key 2% handle, which is the Fed's target. It's all very well and good, the Fed cutting rates as inflation's trending lower, but what happens if inflation's trending back higher? Then the Fed have got a big problem. But if we smooth this out and remove energy costs and indeed remove food costs and look at core inflation, which is the tool the Fed would look at the most, well then it's been quite flat to— well, we had a 2% print for March, which was the lowest reading in more than 12 months. So this is where we started to get a little bit more confident that maybe the Fed are— not only have they ended their rate hiking cycle, they may well be on the verge of starting a new cutting cycle. So 2% for March, but then we bounced back to 2.1% in April. So we'll see. All eyes for me, 1:30 on Wednesday. What is the core inflation print for May? Um, is it 2.1%? Is it 2%? Does it drop? Does it drop below 2%? If it does, well, right, that 3-rate cut idea in 2019, the expectations of that will start ramping higher. However, if core inflation holds at 2.1, or let's just say it goes up to 2.2, well then you're going to see quite a dramatic correction in those expectations. So how is that going to play out in the markets? And let's go flick back to the charts here, because I showed you that stat— all the moves last week were based off this idea that the Fed have turned way more dovish, and then the data was supportive of that with the payrolls figures being so week. So equities through the roof. All these charts you're looking at pretty much are showing moves to the upside. Okay, so if you get a high inflation print on Wednesday, well, this will be the big moment. That'll be the best scenario for traders because, I mean, let me go to a daily chart here for the S&P. You know, quite a phenomenal, uh, week. 5 green candles in a row, 4 of them pretty big ones. And here we are kind of just sat testing that high point that we had, um, back on the 16th of May. And there's definitely room to move back lower off a high inflation print, or so we price back out rate cuts. Okay, however, low in freight— low inflation on Wednesday, and I tell you what, we are not far off the high of the year. We're not far off the all-time high for the S&P S&P. And low inflation print below 2% on Wednesday, that could be the final little catalyst to get stocks ramping back up towards their highs for the year off the back of a more aggressive dovish Fed in terms of rate cuts. Okay, so very critical, this data on Wednesday. Um, let's have a look at gold, which is also very sensitive obviously to that, that kind of rate-cutting scenario. Gold's been lower this morning off the Mexico news, but it's very high still when you look back over the last week. Last week was just extraordinary for gold. Let me just move a few lines here, um, move my lines like that. So we had a big test of the high of the year on Friday, just broke it briefly, but then we pulled back, and this morning we're a little bit lower. Keep your eye on that high point that we have back in March as perhaps support on the way back down here. But for gold, can it break and extend above the February high? Well, only if inflation data on Wednesday is low. If inflation data on Wednesday is high, well then gold's going to move back in here. Um, we got some resistance down here from the mid-May high, uh, the $1,300 handle around that area. Okay, so certainly gold very sensitive to this data coming Wednesday. Uh, finally here, as we're talking about Wednesday, you can't not talk about government bonds in the US, which have ramped higher off the expectation of more rate cuts coming. Um, let me just adjust a few lines here. Um, let me just get rid of that one. So we did make a new high for the year briefly Friday, just breaking above the triple top that we had Monday, Tuesday, Wednesday last week. Uh, but then we pulled back, and this morning marginally lower off the Mexico news. But you can see there's not much appetite to, to sell bonds at this point despite the slight positive sentiment in markets, a reluctance for T-notes to move lower. But if inflation is higher than expected on Wednesday, then there's a lot of room to move back to the downside. The key support of the medium term would be this high point from back in March. Huge amount of room to move back lower here off high inflation as we reduce our rate cut expectations. But of course, T-notes can punch higher and continue this upward trend if inflation is low and our rate cut expectations continue to move north. Okay, so Wednesday, that's what it's all about this week for sure. Okay, just to finish off the briefing then, we can't not talk about the Conservative Party leadership race. If you're in the UK, this is all that the news is interested in. When you go onto the Bloomberg homepage and it's just all about, it's about Rudd, it's about Boris, it's about Gove. Certainly in the UK we're being dominated by this and that will continue to be the case obviously. Here's a little stat, not sure if you can see that that well, just looking at the updated numbers in terms of probabilities. Still the case that Boris is out in front. Be interesting to see what happens to Michael Gove's popularity as we go through the course of this week. Big cocaine scandal blew up in his face over the weekend. This is going back 20 years, mind, but 20 years ago, in his early 30s or whatever, as a journalist, apparently he took cocaine several times at social events. Um, and he's defiant in in the face of this media storm that's, that's hit him. What I would say is, think about Donald Trump. Has Donald Trump changed the way political races pan out? Because don't forget the presidential campaign that Donald Trump went through, that he ultimately ended up being successful in, and the amount of scandals that hit Donald Trump was quite extraordinary. And Yet he plowed on in the face of adversity and then went on to win it. So I think Gove is trying to just play the Trump card, and that is to just bat it off, bat it off, continue talking about his, his policies. Um, he's got quite an interesting policy around revamping VAT, making it a lot more simple, making that tax rate a lot lower, making it more into a bit of a sales tax that kind kind of other countries employ. That would be very positive for, for business. Um, there's, you know, the, the quarterly VAT return that businesses have to do is a real pain, and that, that's quite a popular, um, idea, I believe. But whether it's enough to, um, over, you know, to overshadow the cocaine scandal, I don't know. We'll have to see. But look, Boris still out in front as it stands. Something that's happened over the weekend hasn't got too much attention in some of the press this morning, but definitely interesting for the leadership race, definitely interesting for Brexit. So over the weekend, the UK did a deal with South Korea agreeing a trade deal post-Brexit, and the trade deal says that the EU— sorry, the UK will continue to have a bilateral trade agreement with South Korea that's in line with the trade agreement that they currently have in existence with the EU. So it's like South Korea saying, Great Britain, we'll keep things the same with you as they are with the EU, and we'll give you a deal. Um, certainly it's in South Korea's interests. Um, South Korea, um, export— what is it, I think $6.5 billion worth of goods a year to the UK. Uh, the UK is South Korea's second biggest European market after Germany. That's just because the UK is second biggest economy, but it's an important exporting destination for South Korea, so it's definitely within their interest. The important thing about this is South Korea is quite a big, um, important, uh, export market for UK businesses. Um, and with this deal having been agreed, that's now 12 trade agreements made for post-Brexit. And 12 doesn't sound many when you're thinking that the the number of— I think we need— I think there's something like 61, 62 countries we need to finalize trade agreements with for when we leave the EU, and we've only managed 12. But the point is, the 12 we've managed are some of the big ones. And so actually, 63% of trade currently covered by EU agreements, 63%, have now been agreed bilaterally with the UK. So the reason why I'm pointing this out is because the risk of hard Brexit, the, the risk of the damage that a, let's say, a Boris-led hard Brexit, the risk of that does reduce as more and more of these trade agreements get made. So this might play into Boris's hands a little bit, and maybe the fears around Boris coming in, um, being more aggressive, pushing for a 31st of October, um, no-deal exit. Well, um, and don't forget, that's another— well, what are we, 4 months away? So we may well get a few more of these trade agreements in place. I'm just saying, this, this probably plays into Boris's hands, this kind of development. And Liam Fox has done the business here over the weekend. You could say with Liam Fox, I mean Well, better late than never would be perhaps the best way of describing this, because he had a deadline to agree 62 trade agreements by the 31st of March, and he spectacularly failed in that. But at least he's getting on with it now, and South Korea was one of the final big, big ones to get in the bag. So this is quite an important one. Okay, so plenty of Brexit news as we go through the week. Brexit, I should say UK lead or Conservative Party leadership race and look towards Thursday, first round of ballots for the Conservative leader. We'll talk way more about this as we go through the week, but certainly in the UK the leadership race is going to ramp up and up and up as we go into that first ballot on Thursday. Okay, I'm going to finally finish off with a look at today's calendar just to get back into the mindset what's going on right now. And as I said at the the outset. We've had the Japanese and Chinese data already. We've got some UK figures coming at 9:30, GDP estimates for April. We've got services estimates as well, industrial output and manufacturing output. I wouldn't call— well, maybe the GDP figure. The UK now do release GDP estimates monthly. Most other countries do not. So this is quite a new way of doing things. So as it stands, we're not quite that confident whether this is accurate yet, but we'll see. At least it's a little sneak at quarter 2. Remember, April here, so a little sneak into quarter 2 might be interesting. Other than that, we've got some housing data out of the US— oh sorry, no, that's Canada. We've got JOLTS job opening data out of the US. So really this afternoon, forget about it from a data point of view. A couple of Bank of England speakers on the mic, but otherwise we're expecting a relatively quiet session from a news flow point of view. We've got a slight mild tone to the session with regards to sentiment as a result of the US-Mexico trade agreement. Let's see how, like, how long that can continue. Okay, thanks a lot guys, that's it from the desk. Enjoy your sessions.