Market sentiment recovers on Friday, helped by lower inflation expectations data, less hawkish Fed comments. USD pulls back from 20-year high amidst improvement in risk appetite. China GDP shrinks in Q2 as economy feels the effect of lockdowns

Markets ended what was another very volatile week on a positive note, with the S&P500 rebounding almost 2% and most commodity prices increasing.  Long-term inflation expectations from the University of Michigan’s survey came in lower than expected while Fed officials appeared to downplay the prospect of a 100bps hike later this month, supporting lower global rates.  The USD pulled back from a 20-year high as risk appetite improved, helping the NZD recover to around 0.6160 at the end of the week.  The all-important NZ CPI release takes place this morning.

After a relentless run of bad news on the inflation front, the decline in longer-term US inflation expectations from the University of Michigan survey was welcomed by both the market and the Fed.  5-10 year inflation expectations fell from 3.1% to 2.8% in July (3% expected), its lowest level in a year, no doubt helped by the recent decline in gas prices.  Note the preliminary survey release is based on a relatively small sample size and revisions are common (including last month) when the full survey results are published.  However, the decline in this measure of long-term inflation expectations is consistent with the falls in market-based measures of inflation expectations and other survey-based measures, such as the New York Fed’s 3-year inflation expectations series.  Inflation expectations are a major focus among central banks at present.  As for the University of Michigan’s confidence index itself, it remained at extremely depressed levels, with the index barely budging from its all-time (post-1978) low set last month.

Global rates were lower on Friday, helped by the lower inflation expectations data and some slightly less hawkish comments from Fed officials.  The US 10-year rate was 4bps lower on the session, at 2.91%, as it shows signs of consolidating just under the 3% mark, while the 2-year rate was little changed, despite the market paring back the probability of a 100bps Fed hike later this month.

Atlanta Fed President Bostic, who earlier in the week had said “everything is in play” at the upcoming July meeting, was more circumspect about a 100bps move in his comments on Friday.   Bostic appeared to walk back those earlier comments, saying that “moving too dramatically I think would undermine a lot of the other things that are working well.”  Meanwhile, San Francisco Fed President Daly said her “most likely posture” was a 75bps hike later this month.  The market, which had been pricing a better than even chance of a 100bps hike immediately after the blockbuster US CPI report last week, is now pricing “only” a 20% chance of such a move.

US core retail sales (ex auto and gas) were much stronger than expected, although this partly, if not mostly, reflects higher prices rather than greater volumes.  Indeed, the Atlanta Fed’s GDPNow estimate for Q2 growth fell from -1.2% to -1.5% (q/q% annualised) which, if realised, would see the US in a ‘technical recession’ (defined as two consecutive quarters of negative growth).

Nonetheless, equity investors appeared to welcome the upside surprise to US retail sales as a sign that the US consumer remains in good health, with equities increasing sharply after its release.  The S&P500, NASDAQ and EuroStoxx indices were up between 1.7% and 1.9% on Friday, although all three were still lower on the week.  Also helping the mood in equities, Citi reported better than expected earnings and revenue, with the higher rates backdrop contributing to greater net interest income, seeing its share price rocket 13% higher.

The USD was broadly weaker on Friday amidst the improvement in risk appetite, the DXY index falling 0.4% on Friday from what was a 20-year high.  A day after falling below parity, the EUR rebounded 0.6% to 1.0080 while USD/JPY eased back from 24-year highs to 138.60.

The NZD was stronger on Friday amidst the weaker USD, ending the week at around 0.6160. Despite some volatility, including setting a fresh 2-year low around 0.6060 on Thursday night, the NZD was only slightly lower on the week (-0.4%), outperforming most of the G10 currencies.  We lowered our NZD forecasts on Friday, reflecting a broad-based upward revision to the path of the USD, and now have a central forecast of 0.60 for Q4, with a possible low extending down to 0.57-0.58.

China’s GDP growth was much weaker than expected in Q2 amidst the long lockdown in Shanghai and covid restrictions in other parts of the country and the slowdown in the property industry.  The economy shrank 2.6% in the quarter (-2% expected) with the annual growth rate slipping to just 0.4% y/y.  The government’s 5.5% annual growth target is now widely considered to be out of reach although there are no signs of the authorities deviating from their zero-Covid approach, despite the clear economic damage.  Over the weekend, the PBOC Governor signalled more support to the economy, although the response to date has been relatively cautious.  The likely weak growth trajectory for China is one reason we are pessimistic about the outlook for global growth and, by extension, the NZD, this year.  China’s CSI300 equity index was down over 4% last week while the CNH was off 1.1%.

In the domestic rates market, it was a quiet end to another volatile week, with little change in swap rates across the curve on Friday.  Last week saw a big repricing at the short end of the NZ curve, with the 2-year swap rate 22bps higher, as the market reacted to the shocking US CPI release, with one eye fixed on today’s NZ inflation data.  Consensus is for a 1.5% quarterly increase in headline CPI, which would take the annual rate to a new multi-decade high of 7.1% y/y.  As, if not more, important will be the core inflation measures, including the RBNZ’s Sectoral Factor Model released at 3pm. These were all sitting at around 4% or higher last quarter, well above the top of the RBNZ’s 1-3% inflation target range.  At last week’s MPR the RBNZ alluded to “near-term upside risk” to CPI data.

Over the weekend, the government announced it would extend the fuel excise tax cut (and reduction to public transport fares) to the end of January.  In isolation, this will likely see inflation forecasts reduced somewhat for Q3 and Q4 but increased next year.

Offshore, market focus will mainly be on Europe this week.  First, there is the question of whether Nord Stream 1 gas flows will resume after the pipeline finishes its annual maintenance period on 21 July. If gas flows do not resume meaningfully, European gas prices will surge, prompting Germany and others to enact gas and power rationing with a deep recession all but guaranteed if this were to occur. Second, the ECB meets on Thursday night with consensus expecting a 25bps hike, which would take the deposit rate to -0.25%, although the market is pricing an outside chance of a larger 50bps rate move.  There will also be focus on whether the ECB has any more details on its anti-fragmentation tool, designed to support vulnerable peripheral government bond markets.  Third, Italian politics are back in focus after PM Draghi offered to resign last week, raising the risk of early elections and fresh political instability at a very inopportune moment. Draghi is due to address parliament on Wednesday night, with Bloomberg reporting over the weekend that he is currently expecting to reiterate his decision, although some hold out hope that a new workable majority could yet be cobbled together.  Elsewhere, RBA Governor Lowe is speaking on Wednesday and is likely to be quizzed about whether the RBA would consider a 75bps hike next month given the recent plunge in the unemployment rate and surge in inflation.  The US earnings season also continues, including, among others, BofA, Goldman, J&J, Netflix, and Tesla.