Market Digests Warsh Remarks

MACRO FRAME

Fiscal dominance has returned to the market, though underlying concerns over the deficit and debt burden are driving investors to demand more risk premium in an environment with persistent inflation. Meanwhile, yields have broadly taken a backseat to equity market performance as corporate earnings growth and expectations have set up bullish conditions to continue through the remainder of the year.

STOCK INDEX FUTURES

Equity index futures are starting the week in a cautious risk-off tone as renewed US–Iran military action lifts oil and a hawkish Jackson Hole message from Chair Warsh drives a material repricing of September Fed-hike odds. The immediate pressure point is the combination of rising energy inflation and higher discount rates for technology equities. Strong Q2 results and guidance from megacap technology and AI software/infrastructure companies, especially Nvidia, have reassured markets that AI capex is translating into accelerating revenue growth. However, this support is now facing near-term headwinds from macro and geopolitical risk. US forces struck two Iranian rocket launchers on Larak Island in the Strait of Hormuz on Sunday, the first publicly confirmed US strike on Iranian military positions in more than a month. Iran subsequently launched missiles toward US positions in Jordan, most of which were reportedly intercepted. This week’s JOLTS and payrolls data, together with Broadcom and Dell earnings, will be key catalysts in broader price direction. Strong labor data could reinforce the case for a September hike, while any cooling would be the counterargument to a more hawkish Fed path.

Watch point: Despite tech volatility, the earnings backdrop suggests bullishness, though a September rate hike remains a near-term risk.

CURRENCIES

US DOLLAR: The USD index slipped 0.12% to 99.58 following Warsh’s remarks on Friday that saw the dollar gain 0.55% as markets ramped up bets on September a rate hike. Warsh said the Fed will have work to do if policymakers are not confident that inflation is heading in the right direction, indicating that further tightening may be necessary to curb inflation. The comments fueled bets on a September rate hike and raised the probability of a move next month to 64%, while 2-year yields hover just below one-month highs. Near-term rate hike expectations are likely to dominate price direction, while the markets renewed bets of a September hike have added fresh support for the dollar on top of last week’s hawkish data. Labor data this week will be the new test for the dollar and expectations of a September hike. Elsewhere, the dollar was seeing limited bid against the renewed hostilities in the gulf, after the US struck Iran’s Larak island.

Watch point: The market remains doubtful over a September hike, though the risk of a move upwards in policy should not be discounted given the current inflationary backdrop.

EURO: The euro is little changed at $1.1598. Germany’s EU-harmonized rate rose to a four-month high of 2.9%, below forecasts of 3.1% but still well above the ECB’s 2.0% target. Domestically, inflation rose to its highest level in four months, driven by a renewed surge in energy prices. However, services inflation eased to 2.8% from 2.9%. Core inflation, excluding energy and unprocessed food, was unchanged at 2.4%. Inflation rose in France and Spain in August, mainly driven by higher energy prices. EU-harmonized inflation rose to 2.7% in France, while Spain’s rate landed at 4.5%, a two-year high. Given that a September hike is being taken as a sure thing by markets, any hawkish shift in pricing toward the Fed will weigh on the euro. Money markets are still pricing around 43 bps of tightening this year likely because the ECB remains in a favorable position to adjust on policy. Favorable data in recent months has shown the eurozone economy to prove resilient in the face of higher natural gas prices, which is likely to keep policymakers confident that the economy can withstand additional rate hikes without materially increasing risks to the labor market or consumption.

Watch point: Broader price direction will be subject to Fed-ECB policy expectations, which is likely to be favorable to the EUR in the near-term.

BRITISH POUND: Sterling is little changed at $1.35471. No new data overnight in the UK as markets are closed for holiday. While recent economic data has portrayed a stronger economy than expected, the case for a rate hike from the Bank of England remains wary. Cooling hiring demand and moderating wage growth are reducing near-term inflation risks and factors the BoE will likely acknowledge in upcoming policy meetings as an argument against tightening. We maintain our view that the BoE will hold on rates for the remainder of the year. Markets have are no longer fully priced for a hike by year-end, seeing 24 bps of total tightening. Attention will shift to the parliament resuming session next week, where traders will look for signals on how the Burnham administration is likely to fund certain policies, ahead of the October budget.

JAPANESE YEN: The yen recovered 0.14% to 159.82 yen per dollar. Recent data showed unemployment (2.4%) fell in July to its lowest level in a year, while Tokyo’s inflation rate rose to a five-month high in August. Headline inflation remained below 2% as fuel subsidies and favorable base effects limited the impact of higher raw material costs. However, a gauge excluding fresh food and energy costs and viewed more favorably by the BoJ rose to 2.0% YoY. Bank of Japan Deputy Governor Ryozo Himino offered hawkish comments as expected and did not rule out a September rate hike, though gave little clarity on the pace of future increases. Himino highlighted that growing inflationary pressures could see underlying inflation exceed 2%. Himino also pushed back against the idea that future rate hikes could damage the economy, suggesting that financial conditions remain loose. Markets are pricing a 68% chance of a September hike. Failure to hike at the September meeting would renew pressure on the currency and send the yen back toward the 162 area. Stronger near-term rate hike expectations have kept the yen from sliding as fast as it had been earlier in the summer. However, existing fundamental pressures remain in the form of mounting unease over Japan’s fiscal outlook and debt-load.

Watch point: Failure to raise rates at the Bank of Japan’s September meeting could see the yen drop toward the 162 level.

AUSTRALIAN DOLLAR: The Aussie is little changed at $0.7165. Traders have significantly repriced expectations of a September rate hike following monthly inflation data, which showed prices rose 1.0% in July. The Aussie has gained over 1% in the past week and over 3% in the past month and technically is nearing its May 2022 high of $0.7277. Recent data has suggested that inflationary pressures in the economy have not subsided to the degree in which the Reserve Bank of Australia had expected, prompting markets to reassess their outlook on RBA policy. Household spending rose 1.1% in July, against expectations of a pullback in spending, suggesting strong consumer demand despite higher borrowing costs. Meanwhile, July’s CPI print saw the trimmed mean measure of inflation rise 0.5% to keep the annual pace at 3.6%. Both figures are likely to be a point of concern for the RBA and could fuel the hawks on the board to raise rates once more by year-end. August’s meeting minutes showed that several members were pushing to hike rates, however, noted that upcoming data on inflation, jobs, and GDP ahead of September’s meeting would be needed to further assess the economy. Taken together, this has set up September’s meeting to be more lively than expected. Money markets now see a 57% chance of a hike at the September meeting vs. pricing of 40% on Tuesday and a 14% chance Monday.  Weak labor data has suggested some softness in the labor market, though the data is unlikely to weaken the RBA’s tightening bias heading into Q3 inflation figures.

Watch point: June’s hiring figures have offered some relief on inflationary pressures, though ongoing pass-through into broader prices is likely to be in focus in upcoming data.

TREASURY FUTURES

Yields are little changed across the curve following Friday’s flattening action during Warsh’s Jackson Hole speech. Warsh moderated his views significantly more than his previous comments, leading the market to unwind the recent increase in yields that was driven by concerns about his credibility. Warsh said that the Fed’s 2% PCE target is a “firm, fixed target”. He specifically noted that the target refers to PCE inflation, which is important because there’s been some speculation that Warsh would try to change the inflation index targeted by the Fed.  Warsh also provided his assessment on the current state of the economy after he initially had refused to provide an assessment saying that was equivalent to forward guidance. His remarks over the economy were hawkish, implying that underlying inflation remains too high and that the Fed will have to act if it does not ease, comments in line with other Fed Governors recently. Warsh also sounded skeptical that productivity gains from AI will bring down inflation in the near-term. Instead, he framed the issue as a situation that would likely not impact policy for a while. Money markets have significantly increased odds of a September hike (64%), while November’s meeting is now fully priced for a move higher.

Watch point: For Fed policy, without any forward guidance, the September decision will likely remain a close call.

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