Provocative from a Chinese point of view, Nancy Pelosi's visit to Taiwan and the promised tough response from the Chinese authorities met with a rather tepid market reaction yesterday; the main US indices closed in a moderate minus, the dollar index met resistance at 106.50 and turned lower on Wednesday. The Fed's verbal interventions have brought back to reality dreamy Treasury investors, who have recently been increasing their bets that the central bank will soften the pace of tightening or be forced to cut rates in 2023. Yields on 10-year bonds jumped yesterday from 2.52% to 2.7%, which also provided support for the dollar. The OPEC+ meetings passed without surprises for the market, the participants agreed to moderately increase production.
Pelosi's visit to Taiwan received a lot of attention, primarily because of China's alarming warnings, but further developments showed that an escalation has been avoided. China "retaliated" by banning sand exports to the island, expanding restrictions on fruit shipments to Taiwan, and announcing military exercises from August 4-7. It also became known that the Chinese manufacturer of batteries for electric vehicles changed its mind about investing in the construction of a plant in the United States. That's all.
There were also speculations that China might respond by dumping US Treasuries, causing market instability, but China's decline in Treasury holdings is due to other reasons, most notably the need to sell foreign exchange reserves to contain CNY devaluation. The mainland yuan has been under significant pressure from an outflow of investors who expected the hard lockdowns to trigger a severe slowdown in China. In addition, China could sell bonds as a precautionary measure, alarmed by the case of the freezing of Russian foreign exchange reserves.
A number of Fed officials who spoke yesterday hinted that investors may be delusional in expecting the central bank to slow down policy tightening or that the tightening cycle will quickly give way to an easing cycle in 2023. Loretta Mester said yesterday that she sees no signs of much easing in inflation, and that the risks of wage inflation due to a strong labor market (which will cause spillovers to consumer inflation, aka second-round effects) are high. Therefore, the Fed will raise rates and it will do it vigorously. Comments from other Fed officials also focused on a strong labor market, a major pillar of the economy that keeps the Fed on course. As a result, 10-year yields jumped up yesterday:
The ISM report in the US non-manufacturing sector today pointed to a favorable combination of the dynamics of inflation index and other indicators, including leading ones. The overall figure beat estimates, rising from 55.3 to 56.7 points (forecast 53.5 points). The price index fell from 80.1 to 72.3 points, indicating a weakening increase in inflationary pressure, while the index of new orders rose from 55.6 to 59.9 points and business activity from 56.1 to 59.9 points. The hiring index is getting out of the negative zone - 49.1 against 47.4 points. In general, the report proved to be much better than expected, due to which the dollar was able to bounce even higher:
The raft of upside surprises in the report suggests that the much-discussed “soft landing” by the Fed officials - reducing inflation while preventing the economy from falling into recession is feasible. In my view there is a risk that market players will again price in the outstripping growth rates of the US economy compared to competitors, and therefore better real yield outlook. In turn, this will likely be one of the main bullish drivers of the dollar.