Asia open: PPI to test the soft landing narrative

Markets

Asian stocks are poised for a cautious opening, mirroring the wary sentiment observed on Wall Street as investors brace for key U.S. inflation data. These forthcoming reports are anticipated to play a crucial role in shaping the outlook for Federal Reserve policy, contributing to the market's cautious stance. Investors are particularly sensitive to this data, given its potential to influence interest rate decisions and broader market sentiment. As a result, market participants are likely to tread carefully, awaiting clearer signals from the inflation figures before making significant moves.

As markets settle back into the soft landing narrative, yields have significantly retreated from their highs, and the pricing for the Federal Reserve's trajectory now indicates approximately 43 basis points of cuts for 2024, up from 29 basis points before the May FOMC meeting. Market participants are preparing to navigate the upcoming US Producer Price Index (PPI) data, which represents this weeks first key test for the bullish sentiment that has engulfed cross-asset sentiment following the dovish Fed stance and the weaker US jobs report.

If this month's PPI data doesn't show a decline, there is potential for rates to drift higher, which could lead to a slide in stocks.

Although the options market currently places more emphasis on the Consumer Price Index (CPI), with bets indicating that the S&P 500 might move 1% in either direction following Wednesday's CPI release, the PPI still holds substantial importance. A higher-than-expected PPI could foreshadow a higher core PCE deflator, intensifying concerns about inflation and potentially impacting the Fed's policy trajectory.

As we highlighted in our weekend report, this week's data dump wags two significant tail risks: one tied to warmer inflation concerns and the other linked to weaker growth, raising fears of stagflation.

In either scenario, the market response could be unfavourable. Hence investors remain cautious, as either outcome could trigger a broader stock market sell-off. You wouldn't want to find yourself in a crowded index theatre with investors screaming about inflation or stagflation while dashing for the fire exits.

The first question the new data might be able to address is whether the economic activity we are recording so far in the second quarter is real economic growth or more of an inflationary mirage. Current quarter GDP trackers from the Atlanta Fed and New York Fed are telling wildly different stories about the strength of the real economy right now.

The Atlanta Fed’s current GDPNow forecast for Q2 has risen to a sizzling 4.18% annualized this week, up from just 1.59% back on April 25th. In stark contrast, the New York Fed’s Nowcast slipped to 2.23% from 2.74% the prior week. This divergence underscores the uncertainty surrounding the true state of the economy.

While digging into the Atlanta Fed data, it’s clear that wage growth continues to slide. Given the Owners' Equivalent Rent (OER), which constitutes 34% of core CPI and has a tight correlation to wage growth, this trend could indicate that a series of favourable inflation surprises are on the horizon. If wages continue to decline, it is reasonable to expect OER will decrease as well, potentially leading to a disinflationary economic expansion in the U.S and extremely bullish for stocks.

Housing plays a significant role in explaining why core inflation, which excludes volatile food and energy prices, has stalled in recent months, contrary to expectations of a continued cooling. The Core Personal Consumption Expenditures (PCE) inflation rate was 2.8% in March, a notable drop from the 5.6% recorded in 2022 but only slightly lower than December's figure.

Oil markets

Oil prices have climbed higher following China's announcement that it will begin selling the first batch of its 1 trillion yuan ($138 billion) of ultra-long special sovereign bonds this week. This move is seen as a significant step in boosting economic activity and supporting infrastructure projects, which in turn could increase demand for oil.

Additionally, AAA projects that 38.4 million people will travel by car over the May 23-27 period, setting a record high for the U.S. holiday frequently identified as the kickoff to the summer driving season. If realized, this would mark a 4% increase year-on-year and a 1.9% rise compared to the pre-COVID 2019 Memorial Day weekend.

The combination of China's economic measures and the anticipated surge in U.S. holiday travel is driving optimism in the oil markets. Increased economic activity and travel typically lead to higher fuel consumption, supporting higher oil prices. These factors are likely contributing to the current bullish sentiment in the oil markets.

Forex market

The Ministry of Finance (MoF) and the Bank of Japan's (BoJ) intervention in the foreign exchange (FX) market raises questions about its lasting impact. USD/JPY has historically exhibited a close correlation with the yield spread between US and Japanese 10-year government bonds. However, it's plausible that the currency pair may have overshot the yield spread, potentially leading to a pullback.

Recent indications suggest that the Bank of Japan (BoJ) might accelerate its policy tightening by raising rates, potentially by 15 basis points in July, with the possibility of an earlier move in June. However, an earlier hike in June could be seen as the BoJ succumbing to political pressure. Despite this, there is still potential for Japanese yields to rise further, especially if the bank continues to steadily reduce bond purchases further.

The increase in Japanese yields has yet to substantially affect the yen as it has been offset by wide US vs JP rate differentials. However, the importance of the Bank of Japan's policy tightening cannot be ignored, and it could result in a decrease in USD/JPY towards the 145.00 level later this year, particularly as the Federal Reserve starts to reduce rates, narrowing the policy divergence between the two central banks.