Weak PMI Surveys Cast Doubts on Need for Further Hikes

USD: Weaker PMI surveys trigger pick-up in FX volatility

Yesterday, the major foreign exchange rates displayed heightened volatility; however, they have since stabilized during the Asian trading session leading up to the Jackson Hole event. The dollar index tried to extend its advance beyond the 104.00-level, but this effort proved unsuccessful, causing it to retreat and come closer to the 103.00-level overnight.

The primary catalysts for the increase in foreign exchange volatility were the recent releases of PMI surveys from both Europe and the US. These surveys have reignited investor concerns about a more pronounced deceleration in global economic growth, which in turn has exerted downward pressure on global bond yields. Despite its upward trajectory for most of the month, the 10-year US Treasury bond yield fell below 4.20%, dropping further from Tuesday's peak of 4.36%.

Initially, the US dollar benefited from the release of weaker PMI surveys, particularly as signs of weakness emerged in Europe. The composite PMI for the euro-zone contracted by 1.6 points, reaching 47.0 in August. This marked the weakest reading since November 2020, predominantly driven by a decline in business confidence within the service sector. Unlike the manufacturing sector, the services PMI had maintained levels above 50.0 throughout much of the year, until it fell to 48.3 in August. The most prominent decrease in the service sector PMI was observed in Germany, where it plummeted significantly by 5.0 points to 47.3 during the same month.

WEAKER PMI SURVEYS RE-HEIGHTEN GROWTH CONCERNS 

 Source: Bloomberg, Macro Bond & MUFG GMRThe surveys have understandably heightened investors' concerns about the expanding economic slowdown, indicating a growing likelihood of the euro-zone economy contracting once again in Q3. This follows a modest expansion of 0.3% in Q2. At the very least, these survey results challenge the consensus forecast for economic growth to pick up in the latter half of this year, as the crisis related to the cost of living begins to ease.

The surveys also imply that the European Central Bank's (ECB) efforts in monetary tightening are exerting a more substantial impact on slowing down the economy. This situation should lead the ECB to exercise greater caution when considering any further hikes in the near term. In line with this perspective, I maintain my forecast that the ECB will pause their hiking cycle at the upcoming September policy meeting.

It's worth noting that negotiated wage growth within the euro-zone has remained robust at 4.34% in Q2, persisting for the second consecutive quarter. Looking ahead, a pivotal data release for the ECB before their next policy meeting will be the euro-zone CPI report for August, set to be unveiled on August 31st. Unless there is a significant surprise in core inflation for August, I anticipate that market participants will remain less confident in the possibility of another ECB rate hike in September.

Presently, the euro-zone rate market reflects the pricing in of approximately 14 basis points of hikes for September, implying that another hike is still more likely than not at this juncture. Nonetheless, a decision by the ECB to pause their hiking cycle next month still carries a potential downside risk for euro-zone yields and the euro in the month ahead.

The decline in business confidence during August was also evident in the UK, where the composite PMI sharply fell below the 50.0-level to 47.9. This level is the lowest recorded since January 2021, potentially prompting the Bank of England (BoE) to adopt a more cautious approach toward the necessity of further rate hikes. This suggests that the impact of monetary tightening is beginning to negatively affect economic activity.

Following another surprising increase in wage growth earlier this month, the UK rate market had shifted to pricing in a higher probability of the BoE implementing a larger 50 basis points hike in September. This had also led to the pricing in of around 75 basis points of further hikes. However, after the release of the recent weak PMI surveys, the UK rate market now factors in approximately 21 basis points of hikes in September and a cumulative total of around 61 basis points of further hikes by early next year.

Initially, the pound experienced a sharp sell-off as expectations for BoE rate hikes were scaled back, resulting in cable briefly dropping to a low of 1.615 and EUR/GBP rising to 0.8566. However, these losses were not sustained. Similarly, the initial rally of the US dollar wasn't sustained either, as it was revealed that business confidence had declined in the US. This development cast doubt on recent investor optimism regarding the resilience of US activity data for the year. In August, the US composite PMI decreased by 1.6 points to 50.4. While this remains higher than levels in the euro-zone and the UK, it suggests a trend towards weaker growth.

Furthermore, preliminary benchmark revisions for the US payrolls report indicated a downward revision of -306,000 in employment growth for the year leading up to March 2023. This points towards slightly weaker employment growth. However, this revision is unlikely to have a significant impact on the Federal Reserve's assessment of labor market conditions when determining policy.

I maintain my expectation that the Federal Reserve will leave interest rates unchanged at the upcoming September FOMC meeting. This stance is driven by the slowdown in inflation, even as the US economy has shown signs of resilience recently. In the short term, the US dollar is anticipated to continue deriving support from increasing evidence of economic weakness beyond the US, particularly in China and Europe. Additionally, recent yield spread movements favouring the US should contribute to the sustained strength of the US dollar.

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