Thursday’s Surprises

There were several surprises today.  They began in Asia Pacific with strong Australian jobs data and disappointing Chinese data.  But Australian employment data is volatile, and many had already come to appreciate that the Chinese economy lost some momentum. The surprisingly hawkish guidance from the Bank of England and firmer than expected US CPI may have further reaching implications that the Australian and Chinese developments.  

Sterling posted its third largest advance of the year, rallying about 1.8% against the dollar, following a hawkish hold by the Bank of England.  The 7-2 vote to stand pat was not surprise.  What caught the market off guard was the hawkish assessment that “all policymakers” see as likely the withdrawal of monetary stimulus in the “coming months.” It underscored this by noting that rates may need to rise more than what the market was discounting.  
Recall that at the recent ECB meeting, the pass through of the euro’s strength did not appear to be fully reflected in the updated staff forecasts.  The disconnect at the BOE is that their economy assessment did not appear to change as much as the forward guidance.  The BOE painted a slightly stronger economic picture than last month, citing high frequency data that pointed to a firmer housing market, continued employment growth and a rebound in retail sales, including auto sales.  
The next BOE meeting is November 2.  The market quickly adjusted to an increased chance of a 25 bp hike then.  That meeting will also coincide with the Quarterly Inflation Report, which updates the BOE macro-economic forecasts and views.  The implied yield of the December short-sterling futures contract (50 bp) is about 16 bp higher than it started the month.  It suggests the market has nearly discounted the BOE unwinding the post-Brexit 25 bp rate cut.   The implied yield has not been much higher since late January when it briefly saw 59 bp.  
Sterling posted an outside update and rallied to its highest level since early September 2016.  It poked through $1.34 and hung around there after the London market closed.  Our $1.3430 target, the 50% retracement of the post-referendum sell-off, has been approached.   The 61.8% retracement is found a little above $1.38.  The $1.3885 area corresponds to the 38.2% retracement of the larger down move that began in mid-2014 when sterling was peaked around $1.72. 
The euro had been correcting low against sterling since the start of the month.  The 38.2% retracement of the rally since the April low is found near GBP0.8810, and the 50% retracement is near GBP0.8655.  We cite these not as point forecasts but to give a sense of the magnitude of the correction that is possible.  The prospect of the BOE hiking well before the ECB is done expanding its balance sheet, let alone begin to raise interest rates makes calls for parity seem quaint.  
The somewhat firmer than expected US CPI comes at a time when investors just beginning to refocus on the possibility that having largely failed to make much headway trying to legislate with a slim majority, Trump is seeking better success with a more bipartisan effort.  This has renewed interest in tax reform, for example.   
August CPI rose 0.4%, a touch more than expected, and lifted the year-over-year rate to 1.9%.  The core rate increased by 0.2%.  This may sound like a dog bites man story, but today’s report snapped a string of five core CPI reports below median expectations.  We had warned that the finished consumer goods component of the PPI report warned of upside risks, but in truth the highlight was the record rise in lodging costs (4.4%) and the largest increase in shelter costs since 2005 and the a (5.1%) jump in hotel costs, the most since 1991.   There looks to have been some although modest impact from the hurricane as data from two of the 87 urban centers were disrupted.  
Energy prices rose the most since January, though to be sure this is excluded from the core.  However, the 2.8% rise in gasoline prices could translate to a upside risk in the August retail sales report due before the weekend.  The median forecast in the Bloomberg survey calls for a 0.1% increase in headline, which seems like a low bar to surpass, given gasoline prices and the robust Redbook sales.  Autos sales may have been the main drag,   
The important takeaway is that the risk of a December Fed hike is gradually increasing.  We noted that earlier today, but it is even more true after the CPI.  Consider that a week ago, Bloomberg calculated that the odds implied by the Fed funds futures strip was a little less than 22% for a Dec hike.  Now it calculates the odds at a little more than 45%.  In the CME’s assessment, the odds have risen from 31% to almost 51% today.  
The US dollar found some traction, but nothing convincing, although the euro traded at new lows for the month (a little below $1.1840).  Many are skeptical of these recent developments.  In the foreign exchange market, dollar bounces on ideas of tax reform or more hawkish Fed policy creates opportunities for the dominant dollar bears.   

The greenback toyed with JPY111, a level it has not closed above since late July.  It is also roughly the 50% retracement of the decline since the mid-July high near JPY114.40. The 61.8% retracement is bound near JPY111.75.  Not that there is a one-to-one correspondence between a certain interest rate and dollar-yen level, it is interesting to note that in mid-July when the dollar put in its recent high, the 10-year US yield was near 2.40%, about 20 bp higher than it is now, while the US premium over Japan was about 15 bp higher.  

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