Euro Area Economy Enters Recession as GDP Growth Rate Contracts

A big dollar fall, historically low volatility, lower bond yields, and Wall Street on the march with the S&P 500 joining the Nasdaq in bull market territory - Thursday's global market moves augur well for a strong end to the week in Asia on Friday.

Any optimism could be punctured, however, by inflation data from China. If they are in line with other indicators lately that show Asia's biggest economy is sputtering, China's stocks, bonds and currency may come under renewed heavy pressure.

Consumer prices are expected to decline 0.1% in May and rise 0.3% year on year. April's CPI report showed inflation virtually evaporated, highlighting Beijing's challenge to stimulate enough economic activity and growth to kill the threat of deflation.

It is proving to be a major headache - outright producer price deflation is expected to have intensified in May, with the annual rate of price falls accelerating to 4.3%, according to a Reuters poll. That would be the fastest rate of PPI decline since March 2016.

China's yuan has been sliding to fresh 2023 lows nearly every day for the past three weeks and the main stock indexes have followed a similar pattern, but it's a different story elsewhere.

Revised figures on Thursday showed Japan's economy grew much faster than initially thought over the January-March period, as a post-pandemic pickup in domestic spending and company restocking offset the hit to exports from slowing global demand.

The Japanese yen rallied strongly, also propelled further by a soft U.S. employment indicator to its best day in a month. The weak jobless claims figures torpedoed the dollar more broadly, sank Treasury yields, and cooled Fed rate hike expectations.

This is usually a healthy mix for risk appetite, and so it proved on Thursday. Both the MSCI World index and MSCI Asia ex-Japan indices are course for their second consecutive weekly rise, something neither has managed since March, and Wall Street jumped.

Remarkably, the main measure of U.S. stock market volatility is at a pre-pandemic low, and implied global FX volatility is its lowest in over a year too. That should give Asian markets the platform for a positive day on Friday.

- China CPI inflation (May)

- China PPI inflation (May)

- South Korea current account (April)

In a recent move that showcases confidence in Coinbase Global Inc. despite ongoing regulatory challenges, Cathie Wood's funds have reportedly boosted their holdings of the cryptocurrency exchange's shares. This development comes on the heels of the Securities and Exchange Commission's (SEC) accusations against Coinbase and Binance Holdings Ltd., alleging the operation of unlawful exchanges¹.

As reported by Bloomberg¹, Cathie Wood's investment firm held over 11.7 million Coinbase shares, equivalent to 6.3% of the total outstanding shares, as of March 31. Wood's decision to increase her stake in Coinbase even as the SEC intensifies its scrutiny reflects her belief in the long-term potential of the company.

Coinbase, one of the most prominent cryptocurrency exchanges globally, has faced growing regulatory scrutiny as authorities seek to address potential risks and ensure investor protection within the crypto market. The recent accusations by the SEC have sent shockwaves through the industry, as major players like Coinbase and Binance find themselves in the regulatory crosshairs.

Responding to the SEC's allegations, Coinbase has taken a bold stance, expressing its willingness to pursue legal avenues, even up to the Supreme Court¹. This indicates the company's commitment to defending its position and seeking clarity regarding the legal framework within which it operates.

Cathie Wood's decision to bolster her holdings in Coinbase amidst these challenges adds weight to the belief that the company can navigate the regulatory landscape successfully. Wood's investment firm, known for its focus on disruptive technologies and innovation, has gained considerable attention due to her successful bets on companies like Tesla and Square.

The actions of prominent investors such as Cathie Wood often signal their confidence in the future prospects of a company. By increasing her stake in Coinbase, Wood is displaying her conviction that the ongoing regulatory issues will eventually be resolved and that Coinbase can continue to grow and provide value to its shareholders.

The SEC's widening crypto crackdown, which now encompasses both Coinbase and Binance, underscores the importance of regulatory compliance within the rapidly evolving cryptocurrency ecosystem. Market participants are closely watching how these regulatory challenges unfold and how they may impact the future of the industry.

As the legal battle between Coinbase and the SEC continues, the outcome will have far-reaching implications for the broader crypto market. Investors, industry stakeholders, and enthusiasts will be eagerly awaiting further developments, looking for signs of regulatory clarity and the potential impact on the overall adoption and acceptance of cryptocurrencies.

There are three main factors that could alter the Fed’s decision-making framework and prompt it to step back from its hiking cycle after a hiatus:

The Fed very rarely raises rates again after pausing when policy is already restrictive.

Inflation will keep falling in the coming months, while labor-cost pressures are being revised significantly lower.

The jobs market is weakening fast.

It might be a surprise, but it’s rare indeed for the Fed to re-tighten policy after pausing. It’s even rarer for it to do so when rates are already restrictive.

Moreover, as the chart below shows, the instances of this in the early 80s occurred when rates were in a longer-term downtrend, unlike today. It would thus be almost unprecedented (albeit not impossible) for the Fed to raise rates again after pausing.

By several measures, rates are already very restrictive. Real policy rates are about to be above r*, the estimate of neutral. It’s an imperfect measurement with many assumptions. But inflation-fixing swaps see the real Fed rate at 2%-2.5% through summer, well enough above the latest r* estimate of about 0.6% to indicate policy is indeed restrictive.

This is underscored by the yield curve’s inversion, which is giving us a transparent read on how restrictive rates are. The 3m-10y curve is almost a facsimile of the degree of restriction in the real policy rate.

It’s no wonder some banks went under. The heavily inverted curve is a barometer of rate stress building up in the system, and a reminder that other unexpected grenades could go off and upend the Fed’s current outlook.

The inflation backdrop will also look very different in the coming months, with headline CPI set to fall to near 3%, according to fixing swaps. Core CPI should also keep falling for now, based on leading indicators.

The Fed is focused on wage growth for inflationary signs. But real wages are either still negative or barely positive, depending on what measure of compensation you use.

Furthermore, wage pressures are not nearly as high as they were thought to be. Last week’s release of employment data saw significant downward revisions to real hourly compensation and unit labor costs for the last quarter of 2022, as seen in the last two columns in the table below.

The jobs situation may look very different soon too. Remember that unemployment is one of the most lagging indicators. Typically, the labor market looks in reasonable shape when a recession is already underway. It’s also not unusual to see some unexpectedly high payrolls numbers at this time (even if they may well be subsequently revised much lower).

It’s prudent instead to focus on the most forward-looking employment indicators. Two of these are temporary help and average weekly hours worked. Employers are likely to cull temp workers and cut full-time employees’ hours before they move to sacking people. This is also why more lagging measures of employment tend to hold up until after the recession has begun.

Both temp help and hours worked are falling quickly. The jobs situation – and therefore the Fed’s risk-reward for hiking rates again – could look sizably different in the coming months, especially as a near-term recession looks exceedingly likely.

The megacap-styled elephant in the room is the stock market. Can the Fed cut rates when there is a veritable buying frenzy in a few corners of the market?

You might expect the market to bounces the Fed into a rate cut by selling off first. But that’s not what has happened on average over the last 30 years. As the chart below shows, the S&P tends to rally into the first Fed cut of the cycle.

Moreover, the chart also shows this is the same for the largest stocks, which are driving today’s market higher. The Top 5 Index rallies into the first rate cut and continues to do so afterward.

Canada and Australia’s recent rate hikes are adding a dose of uncertainty to the Fed’s outlook. This may add more volatility to anticipated policy rather than policy itself.

Nevertheless, the Fed will have an increasing number of off-ramps allowing it to refrain from further hikes. And the longer it does so, the more the backdrop will favor policy loosening. The pause that refreshes may end up being the prelude to a cut.

While most large equity markets in the Asia Pacific region fell today, Hong Kong and China's CSI 300 rose. The Stoxx 600 in Europe has drifted a little lower. If sustained, it would be the third loss this week. US equity futures are steady to slightly firmer. Benchmark 10-year yield are mixed in Europe. Peripheral yields are 1-3 bp lower while the core is flattish. UK Gilts and Swedish bonds are under more pressure and yields are 3-4 bp higher. The softer US dollar is helping gold stabilize after recording a bearish outside down day yesterday. It closed on its lows near $1940 but has not taken it out, and it is held slightly below $1950. July WTI reached $75 on Monday following the Saudi's unilateral cut of an additional 1 mln barrels a day in output (starting next month). However, it fell back to $70 on Tuesday and is in near the middle of that $5-range today.

Japan revised Q1 GDP to 2.7% annualized from 1.6%. The revision was driven by stronger business spending (1.4% vs. 0.9% initially), which was signaled by the stronger than expected capital spending (11% year-over-year vs median forecast in Bloomberg's survey for 6.0%). The other notable revision was with inventory accumulation. They boosted GDP by 0.4% percentage points rather than 0.1%. Nevertheless, a poll by Bloomberg found only 3 of 47 economists now expect a tightening move next week, down from 18 in last month's survey. Now, a little more than a third of the respondents see July as the more likely timeframe. A fifth look for a change after the summer, up from 10% in the previous survey. Meanwhile, foreign investors continue their buying spree of Japanese equities for the 10th consecutive week. Japanese investor sales of foreign bonds last year were thought to be strategic, but it looks increasing tactical. Last year, they sold about JPY21.7 trillion (~$165 bln). In the first 22 weeks of the year, Japanese investors have bought about JPY12.1 trillion back.

The decline in China's May exports and imports underscored concern about the world's second-largest economy. After banks cut deposit rates at the request of Beijing, the market was already primed for a likely cut next week in the benchmark 1-year medium-term lending facility (2.75%). Tomorrow's inflation data will likely confirm what we already know. Consumer inflation is amazingly low (0.1% year-over-year in April) and producer price deflation (-3.6% in April). May will be the eighth consecutive month of negative year-over-year PPI. China's discount to the US on 10-year yields widened to almost 108 bp yesterday. The low for the year was set in early April near 114 bp. Last year, it reached almost 153 bp, the most since 2007.

Australia reported a 5% fall in exports in April, the largest monthly fall since last July. Imports rose 1.6%, half of the March pace. The net result was a smaller than expected trade surplus of A$11.16 bln. Last April, Australia recorded a trade surplus of A$12.95 bln. Still, the trade surplus has grown this year, from A$41.7 bln in the first four months of 2022 to A$51.1 bln this year. Of note, Australian exports of iron ore and other metals fell in April (-10.4%). Canberra's trade relationship with China, its biggest partner has improved and exports to China are up about 13.6% in the January-April period. Inbound tourism, which has also been an important component of Japanese consumption, rose by nearly 14% in April (travel exports).

The 12 bp increase in the US 10-year yield yesterday helped the dollar post an outside up day against the yen. After trading below Tuesday's low, the dollar reversed and closed above its high. It held below Monday's high (~JPY140.45). Yet, despite the bullish price action, there has been no follow-through dollar buying. The greenback is trading quietly in a roughly JPY139.65-JPY140.25 range. Watch US 10-year yields for the direction cue in the North American session today. It is nearly flat just below 3.80%. The Australian dollar was sold yesterday after popping above $0.7000 but reversed lower. Here, too, there has been no follow-through US dollar buying, and the Aussie is consolidating in the $0.6650-$0.6690 range. Options for nearly A$710 mln expire today at $0.6950. A close above $0.7000 lifts the technical tone. We had thought the CNY7.07-CNY7.11 was a reasonable target, but it has surpassed it. The next nearby chart of note is around CNY7.16-CNY7.20. Recall that last year's high (November 4) was near CNY7.3120. The dollar is snapping a four-day advance today. Since May 5, it is only the fifth losing session. And even it is minimal. The dollar settled near CNY7.1350 yesterday and held CNY7.1260 today. The reference rate was set at CNY7.1280 today, a smidgeon below the CNY7.1282 median forecast in Bloomberg's survey.

The downward revision in the eurozone's Q1 GDP to -0.1% from +0.1% doses not really change anything. The ECB meets next week and there is little doubt in the market's mind about the outcome. A quarter-point hike will bring the deposit rate to 3.25%. The swaps market fully prices in another hike in Q3. The ECB will update its forecasts next week too. In March, it had forecast this year's growth at 1.0% year-over-year. The median in Bloomberg's survey is 0.6%. The World Bank is even more pessimistic with a forecast of 0.4%. The IMF and OECD are closer to the ECB at 0.8% and 0.9%, respectively.

The ECB published the results of its April survey of consumer expectations yesterday. The 12-month outlook fell to 4.1% from 5.0% in March. The three-year expectation eased to 2.5% from 2.9%. The ECB's March forecasts had CPI rising 5.3% this year and 2.9% next year. The median forecast in Bloomberg's survey is for CPI to be at 5.6% at the end of this year and 2.5% at the end of 2024.

So far this week the euro has chopped inside the range set last Thursday, before the US jobs report (~$1.0660-$1.0770). More pointedly, the euro has held below $1.0740, which was about the (38.2%) retracement of the rally from the March 15 low near $1.0515. Although it enjoys a firmer today, it is inside yesterday's range. There is greater uncertainty around the Fed meeting and than the ECB meeting next week. There may be little incentive ahead of the FOMC meeting (and CPI) for speculators to make a big push in either direction. We note that after rising from below 120 bp in early May to around 170 bp earlier this week, the US premium over Germany on two-year money appears to be stabilizing. Except for spending Monday morning on its back foot in Europe, sterling too is mostly consolidating within the range set last Thursday (~$1.2400-$1.2540). It is enjoying a firmer bias today, has held below yesterday's high near $1.25. Also, sterling's five- and 20-day moving averages crossed higher for the for the first time in three weeks. Still, unless it can rise above the $1.2500-40 area, sterling may be vulnerable. Sterling has fared better than the euro, which had fallen from GBP0.8835 in early May to about GBP0.8565 last week, the low for the year. It is straddling the GBP0.8600 area today.

The Bank of Canada ended its "conditional pause" with a quarter-point hike yesterday, which lifted the target rate to 4.75%. As we have noted Canada was the fastest growing economy in the G7 in Q1. It judged that "overall, excess demand in the economy looks more persistent than anticipated." The statement also cited the uptick in inflation and rebound in the housing market to explain its decision. Deputy Governor Beaudry's speech in Victoria, BC later today is expected to provide more insight into the decision. It may pose headline risk because the market has decided that yesterday's hike was not simply an insurance policy, given the growth was concentrated in January and inflation expectations (break-evens) are trending lower, but the resumption of the tightening cycle. The swaps market is pricing in almost a 75% chance of another hike at the next meeting on July 12. And the year-end rate implies around a 60% chance of one more. Separately, from an economic point of view, the Canadian wildfires are likely to weigh on May and June GDP.

Today's US data, which includes weekly jobless claims and wholesale inventories, are unlikely to have much impact. The US also sees the Q1 household net worth report. It does not move the market, but it is important. Last year was the first year since 2008 that household net worth did not increase. On the other hand, over the past five years (20 quarters), US household net worth has risen by $44.2 trillion. Over the last ten years (40 quarters), it has risen by $75.8 trillion.

The market pushed the dollar to a new seven-year low against the high-flying Mexican peso ahead today's CPI report. Mexico reports CPI for the second half of May as well as for the whole month. The headline rate is expected to fall below 6% for the first time in nearly two years. In the first four months of the year, Mexico's CPI has risen at an annualized rate of almost 4.5%. The core rate is running nearly twice as hot. The central bank is done raising rates and the swaps market is pricing in a cut before the end of the year.

The Bank of Canada's hike saw a quick drop in the greenback from around CAD1.3400 to CAD1.3320. Its lowest level in a month and the US dollar has not traded below CAD1.33 since mid-February. However, the heavier tone in S&P 500 and broadly firmer US dollar saw it recover to almost CAD1.3400. Both ends of the recent range (~CAD1.33-CAD1.3650) have recently been tested and they held. Prudence dictates that we assume the range holds until proven otherwise and that means opportunities exist as the range extreme is approached. The US dollar recorded today's low so far in the European morning near CAD1.3335. Initial resistance is seen in the CAD1.3360-80 area. The greenback was sold to nearly MXN17.3055 yesterday and recovered to settle around MXN17.3650. It has not been above MXN17.37 today. Although the exchange rate is at levels not seen since 2016, as the dollar has fallen, volatility has eased. One-month implied vol is near 9.7% now and is approaching the low for the year set in early February closer to 9.3%, which matches the 2022 low. The relatively low volatility is an important consideration for carry-trade strategies. By comparison, one-month BRL vol is almost 13% and around 15.2% for the COP.

Japan's bitter memories of its decades-long battle with deflation hang heavily over the central bank's deliberations to take its first modest step away from ultra-loose monetary policy, even as inflation and wages creep up.

The appointment of Kazuo Ueda as Bank of Japan (BOJ) governor this year and mounting price pressures have fired up market chatter that the new chief might hasten an exit from the bold stimulus of his predecessor Haruhiko Kuroda.

But uncertainty over the wage outlook and emerging global economic weakness heighten the chance the BOJ will hold off tweaking its controversial yield curve control (YCC) policy at least until autumn, say three sources familiar with its thinking.

"In a country that has seen interest rates stay ultra-low for two decades, the shock of the BOJ's first move could be enormous," said one of the sources. "That's enough to make the BOJ cautious."

Japan has not seen interest rates rise since 2007, when the BOJ hiked short-term rates to 0.5% from 0.25% in a move later criticised for delaying an end to price stagnation.

Having taken part in Japan's battle with deflation as BOJ board member from 1998 to 2005, Ueda knows all too well the danger of a premature exit from ultra-loose policy.

Wary of a wobbly recovery, he opposed the BOJ's decision in 2000 to raise short-term rates to 0.25% from zero.

The bank drew significant political heat for that tightening and was forced to reverse course just eight months later and adopt quantitative easing.

Given the trauma of such ill-timed policy shifts, caution will be Ueda's priority, the sources say, suggesting an end to YCC, which caps the 10-year bond yield around zero, could be some time away. That would mean more significant policy changes are even further down the track.

"Tweaking the yield cap alone may not do much harm to the economy, as long as short-term rates are kept low," one of the sources said. "But the BOJ's long, historical struggle with deflation can't be taken lightly."

One key difference between the BOJ's and the market's thinking lies in Japan's inflation outlook.

On the surface, conditions for phasing out a portion of the BOJ's massive stimulus appear to be falling in shape.

Core consumer inflation hit 3.4% in April, holding above the BOJ's 2% target for over an year, as companies continued to hike prices for a broad range of goods and services.

Companies offered pay hikes not seen in three decades in this year's wage talks with unions, heightening hope of a sustained rise in pay after decades of stagnant wage growth.

With robust domestic demand offsetting some of the external headwinds, the BOJ is widely expected to raise this year's inflation forecasts at its next quarterly review in July.

But inflation is now less of a trigger for an exit than it was in the past, as policymakers focus on risks that could again upend the path toward a sustained recovery.

"If you know the U.S. economy could slow sharply due to aggressive rate hikes in the past, it's natural for the BOJ to be cautious about phasing out stimulus," a third source said.

Weakness in China, a major market for Japanese manufacturers, also casts doubt over whether companies can reap enough profits to sustain wage hikes next year.

To be sure, Ueda has left scope to tweak YCC in case inflation continues to overshoot the BOJ's forecasts. At his debut policy meeting in April, he removed guidance pledging to keep rates at "current or lower levels."

In a group interview last month, Ueda said the BOJ could tweak YCC "if the balance between the benefit and cost of our policy shifts."

With Kuroda's massive stimulus having failed to re-anchor inflation expectations around the BOJ's target, however, Ueda has good reason to be cautious.

Ueda last month said eradicating Japan's entrenched deflationary mindset remained a difficult challenge and warned moving too quickly on rates was more dangerous than not moving fast enough.

"The cost of waiting for underlying inflation to rise until it can be judged that 2% inflation has fully taken hold is not as large as the cost of making hasty policy changes," he said.

Worries that have dogged U.S. stocks for months are fading, pushing some Wall Street firms to raise their outlooks for equities and beckoning investors who have remained on the sidelines.

Signs of strength in the economy, relief over a deal to raise the U.S. debt ceiling and an interest rate hiking cycle that may be nearing its end have heartened investors and driven the benchmark S&P 500 up nearly 20% from its October low - one definition of a bull market.

Further gains may hinge on whether investors who cut stock allocations to the bone over the last year return to the market. Cash on the sidelines is plentiful: U.S. money market fund assets hit a new record of $5.8 trillion last month, while cash levels among global fund managers remain high relative to history, according to the latest survey from BofA Global Research.

And while computer-driven strategies have been piling into the market for months, according to Deutsche Bank, positioning among discretionary investors -- a cohort that includes everyone from active mutual funds to retail investors -- is lighter than it has been 74% of the time since 2010, the bank's data showed.

"There certainly seems to be a bit of a more optimistic ring to the market," said Chuck Carlson, chief executive officer at Horizon Investment Services. "Further strength might beget further strength because of the FOMO factor," he added, using the popular acronym for "fear of missing out."

A stronger-than-expected U.S. economy is one reason for investor optimism, after many spent months girding for a widely expected recession.

Data on Friday showed U.S. job growth accelerated in May, even as the unemployment rate rose to a seven-month high – bolstering the case for those betting the Fed can contain inflation without badly damaging growth.

"Inflation has clearly subsided, and yet labor market strength has remained intact," wrote BMO Capital Markets chief investment strategist Brian Belski in a recent note.

While a severe recession was his biggest worry at the start of the year, now “the anticipated recipe for disaster is simply not present.”

BMO raised its year-end S&P 500 price target to 4,550 from 4,300. The index, which is up 11% year-to-date, closed at 4,267.52 on Wednesday. It is up 19.3% since Oct 12.

Other firms that have issued rosy targets in recent days include Evercore ISI, which now sees the S&P 500 at 4,450 at year end, up from its prior view of 4,150, and Stifel, which anticipates the index will reach 4,400 by the third quarter. BofA late last month raised its year-end target for the index to 4,300 from 4,000.

Another key risk dissipated last week when Congress passed a bill to suspend the debt ceiling, averting a potentially catastrophic U.S. default.

“Moving past the debt ceiling and at least having some economic data that looks ok is actually enough to get some people interested,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.

Lerner on Monday shifted his expected S&P 500 range for this year up to 3,800-4,500, from 3,400-4,300 previously, citing improving earnings trends among other factors.

At the same time, investors have been cheered by signals that the Fed is unlikely to deliver many more of the rate increases that shook markets over the last year. Bets in futures markets showed investors projecting the Fed would leave rates unchanged at its June 13-14 monetary policy meeting and raise them only once more this year.

Of course, plenty of skeptics remain.

John Lynch, chief investment officer for Comerica Wealth Management, said the S&P 500 could retest its October lows with "elevated interest rates and tighter credit standards weighing on economic activity for the remainder of the year."

Another worrisome signal is the fact that the S&P 500's gain this year has been spurred by just a handful of megacap stocks like Microsoft and Nvidia, which have been fueled in part by excitement over advances in artificial intelligence, while large areas of the market have languished.

For Hans Olsen, chief investment officer at Fiduciary Trust Co, that's an ominous sign. Olsen believes signals such as the inverted yield curve show recession risks remain “pretty high” and his firm is maintaining higher than typical cash levels.

“We have one powerful rally inside a bear market that has yet to be fully resolved,” he said.