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CPI YoY development. Source: FXStreet

Core CPI YoY development. Source: FXStreet

Sources: FXSTREET

Sources: FXSTREET

Investors are on the edge of their seats, waiting for the latest scoop on US inflation data to take a fresh direction in both stock and bond markets. The dollar index remains offered, the US political risks are casting shadows, and there’s a rising chorus of opinions playing the guessing game on when and how much the Fed might trim the rates next year.

The S&P500 consolidated on Monday after a 7.5% rally since end of October, while Nasdaq 100 eased 0.30% following an almost 10% rally. The US 10-year yield steadied a touch above the 4.60% level.

According to the consensus of analysts on a Bloomberg survey, the US inflation may have slowed to 3.3% last month, from 3.7% printed a month earlier. Core inflation is seen unchanged at 4.1%. The waning supply chain disruptions, the loosening US jobs market, a further fall in gasoline prices and the expectation of a decline in rents are among the major factors that could help inflation ease – after a more than 1.5-year aggressive policy tightening from the Fed of course.

But not all indicators are in green. An uptick in health insurance costs could give a slight boost to October inflation figures, while the latest US consumer survey, released last Friday, showed that the US consumers expect inflation to climb at an annual rate of 3.2% over the next 5 to 10 years. In contrast, economists see inflation fall to 2.5% in the next five years and down to 2.2% in the next 5 to 10 years, and the bond prices imply a CPI of 2.36% in the period of 5 to 10 years from now.

For today, an inflation read in line with expectations, or ideally softer than expected, should give further support to the Federal Reserve (Fed) doves, cement the idea that the Fed is done hiking the interest rates and boost the rate cut expectations for next year. A read above expectations should bring Fed hawks back to the market and increase the bets of a rate hike in December. But activity on Fed funds futures gives around 85% chance for a no rate hike in the Fed’s December meeting, and the inflation numbers must look very bad to reverse that expectation.

And anyway, what investors are interested in right now is not whether the Fed will hike one more time or not – because they are convinced that it won’t. Instead, what everyone is trying to figure out right now is: when will the Fed start cutting rates, and by how much will it cut rates next year. Goldman Sachs doesn’t expect a rate cut from the Fed until this time next year. Morgan forecasts two deep rate cuts next year starting from June, and UBS’ Investment Bank anticipates the first rate cut as early as in March and a 275bp cut in 2024.

If inflation continues to ease and the US jobs market and the economy starts slowing – which is our base case scenario for the next 12 months – the Fed should start lowering rates. But given how reactive the Fed has been to mounting inflation, the rate cuts shouldn’t start before September, but when they start the loosening should be rapid.

Ceteris paribus, the US 2-year yield should hover around the 5% mark, the 10-year yield will remain appetizing approaching the 5% mark – and could hardly go above this level unless there is an economic shock, or a political turmoil, and a potential rating downgrade.

The US dollar index remains offered at the 50-DMA and could further extend losses with the sight of a sufficiently soft inflation report, while the USDJPY was sold near the 152 level. There are different rumours regarding the nature of the sudden jump in the yen on Monday. It could be a direct FX intervention, or it could be the result of options positioning. But in both cases, selling the yen at the current levels means taking the risk of a sudden reversal, either because of a broadly softer US dollar, or because of a direct intervention.

Article Source: ACTIONFOREX

China's yuan inched lower against the dollar on Tuesday, pressured by market expectations of further widening of yield differential in favour of the United States, amid growing bets of monetary easing in the world's second-largest economy. State-owned newspapers said on Tuesday China can lower banks' reserve requirement ratios (RRR) before the year-end to replenish financial system liquidity.

The RRR cut should reduce lenders' financing costs and support an economic recovery, although it would inevitably widen the yield gap between China and other major economies and pile downward pressure on the yuan, traders said. "Such a move (to cut RRR) would align with efforts to alleviate pressures on banks, particularly concerning their shrinking net interest margins," said Tommy Xie, head of Greater China research at OCBC Bank.

"Market participants will be keenly observing the developments this week, anticipating whether China will announce a new round of RRR reduction." In the spot market, the onshore yuan opened at 7.2861 per dollar and was changing hands at 7.2931 at midday, 46 pips weaker than the previous late session close. Prior to market opening, the People's Bank of China (PBOC) set the midpoint rate, around which the yuan is allowed to trade in a 2% band, at 7.1768 per dollar, 1 pip firmer than the previous fix of 7.1769

The official midpoint fixing continued to come in stronger than market projections, traders and analysts said, interpreting it as an official attempt to rein in excessive yuan weakness. Tuesday's guidance rate was 1,117 pips stronger than Reuters estimate of 7.2885. Market participants now shifts their attention to the PBOC's loan operations on Wednesday, when it is poised to offer 850 billion yuan worth of medium-term lending facility (MLF) loans. Markets will closely gauge the amount of liquidity offered and the borrowing costs set to glean clues on authorities' official stance. "With deflation risks rising, we do not think stimulus measures taken so far will have much lasting impact and we so look for more in the coming months," said Win Thin, global head of currency strategy at Brown Brothers Harriman, expecting the PBOC to keep the one-year MLF rate unchanged at 2.5%. By midday, the global dollar index rose to 105.693 from the previous close of 105.631, while the offshore yuan was trading at 7.301 per dollar.

The yuan market at 0333 GMT: ONSHORE SPOT: Item Current Previous Change PBOC midpoint 7.1768 7.1769 0.00% Spot yuan 7.2931 7.2885 -0.06% Divergence from 1.62% midpoint* Spot change YTD -5.39% Spot change since 2005 13.48% revaluation Key indexes: Item Current Previous Change Thomson 0.0 Reuters/HKEX CNH index Dollar index 105.693 105.631 0.1 *Divergence of the dollar/yuan exchange rate. Negative number indicates that spot yuan is trading stronger than the midpoint. The People's Bank of China (PBOC) allows the exchange rate to rise or fall 2% from official midpoint rate it sets each morning. OFFSHORE CNH MARKET Instrument Current Difference from onshore Offshore spot yuan 7.301 -0.11% * Offshore 7.1025 1.05% non-deliverable forwards ** *Premium for offshore spot over onshore **Figure reflects difference from PBOC's official midpoint, since non-deliverable forwards are settled against the midpoint.

Article Source: zawya

Hamas’s barbaric massacre of at least 1,400 Israelis on October 7, and Israel’s subsequent military campaign in Gaza to eradicate the group, has introduced four geopolitical scenarios bearing on the global economy and markets. As is often the case with such shocks, optimism may prove misguided.

In the first scenario, the war remains mostly confined to Gaza, with no regional escalation beyond the small-scale skirmishes with Iranian proxies in countries neighboring Israel; indeed, most players now prefer to avoid a regional escalation. The Israel Defense Forces’ Gaza campaign significantly erodes Hamas, leaving a high civilian casualty toll, and the unstable geopolitical status quo survives. Having lost all support, Israeli Prime Minister Binyamin Netanyahu leaves office, but Israeli public sentiment remains hardened against accepting a two-state solution. Accordingly, the Palestinian issue festers; normalization of diplomatic relations with Saudi Arabia is frozen; Iran remains a destabilizing force in the region; and the United States continues to worry about the next flare-up.

The economic and market implications of this scenario are mild. The current modest rise in oil prices would recede, because there will have been no shock to regional production and exports from the Gulf. Though the US could try to interdict Iranian oil exports to punish it for its destabilizing role in the region, it is unlikely to pursue such an escalatory measure. Iran’s economy would continue to stagnate under existing sanctions, deepening its dependence on close ties with China and Russia.

Meanwhile, Israel would suffer a serious but manageable recession, and Europe would experience some negative effects as modestly higher oil prices and war-driven uncertainties cut into business and household confidence. By reducing output, spending, and employment, this scenario could tip currently stagnant European economies into mild recessions.

In the second scenario, the war in Gaza is followed by regional normalization and peace. The Israeli campaign against Hamas succeeds without producing too many more civilian casualties, and more moderate forces – such as the Palestinian Authority or an Arab multinational coalition – take over administration of the enclave. Netanyahu resigns (having lost the support of just about everyone), and a new moderate center-right or center-left government focuses on resolving the Palestinian issue and pursuing normalization with Saudi Arabia.

Unlike Netanyahu, this new Israeli government would not be openly committed to regime change in Iran. It could secure the Islamic Republic’s tacit acceptance of Israeli-Saudi normalization in exchange for new talks toward a nuclear deal that includes sanctions relief. That would allow Iran to focus on urgently needed domestic economic reforms. Obviously, this scenario would have very positive economic implications, both in the region and globally.

In the third scenario, the situation escalates into a regional conflict that also includes Hezbollah in Lebanon and possibly Iran. This could happen in several ways. Iran, fearing the consequences of Hamas being eliminated, unleashes Hezbollah against Israel to distract it from the operation in Gaza. Or Israel decides to address that risk by launching a larger pre-emptive strike on Hezbollah. Then there are all the other Iranian proxies in Syria, Iraq, and Yemen. Each is eager to provoke Israel and US forces in the region as part of its own destabilizing agenda.

If Israel and Hezbollah do end up in a full-scale war, Israel would also probably launch strikes against Iranian nuclear and other facilities, likely with US logistic support. After all, Iran, which has devoted massive resources to arming and training both Hamas and Hezbollah, would likely use the broader regional turmoil to make the final leap across the nuclear-weapons threshold.

If Israel – and possibly the US – bomb Iran, production and exports of energy from the Gulf would be set back, possibly for months. This would trigger a 1970s-style oil shock, followed by global stagflation (rising inflation and lower growth), crashing stock markets, volatility in bond yields, and a rush into safe-haven assets like gold. The economic fallout would be more severe in China and Europe than in the US, which is now a net exporter of energy and could tax domestic energy producers’ windfall profits to pay for subsidies to limit the negative impact on consumers (households and non-energy firms).

Finally, in this scenario, the Iranian regime remains in power, because many Iranians – even regime opponents – rally behind it in the face of an Israeli/US attack. All parties in the region become more radicalized and confrontational, making peace or diplomatic normalization a pipe dream. This scenario may even doom Biden’s presidency and his re-election chances.

In the fourth scenario, the conflict also spreads across the region but there is regime change in Iran. If Israel and the US do end up attacking Iran, they will target not only nuclear facilities but also military and dual-use infrastructure, as well as regime leaders. Rather than supporting the regime, Iranians – who have been protesting morality-police abuses for over a year – may rally behind moderates like former President Hassan Rouhani.

The toppling of the Islamic Republic would allow Iran to rejoin the international community. There would still be a severe global stagflationary recession, but the stage would be set for greater stability and stronger growth in the Middle East.

How likely is each scenario? I would assign a probability of 50% to the preservation of the status quo; 15% to a post-war outbreak of peace, stability, and progress; 30% to a regional conflagration, and only 5% to a regional conflagration with a happy ending.

The good news, then, is that there is a relatively high chance – 65% – of the conflict not escalating regionwide, implying that the economic fallout would be mild or contained. The bad news, however, is that markets are currently assigning only at best a 5% probability to a regional conflict that would have severe stagflationary effects around the world, when a more reasonable figure is 35%.

Such complacency is dangerous, especially considering that the combined probability of a globally disruptive scenario (one, three, and four) is still 85%. The most likely scenario might have only mild short-term consequences for markets and the global economy, but it implies that an unstable status quo will remain in place, eventually leading to new conflicts.

For now, markets are priced for near-perfection and favor the mildest scenarios. But markets have often mispriced major geopolitical shocks. We should not be surprised if it happens again.

Article Source: zawya

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