Euro back up over $1.16 and Brent below $80/barrel

The reduction in interest rate expectations continues to see bonds rally across the curve. 10-year German yields were down another 3bps and closer to 2.9%, the lowest they have been since the start of March, and down about 25–30bps from where they were in mid-May. US 10-year Treasury yields were down 4bps to 4.44% and UK 10-year gilt yields were down 2bps to 4.79%. With the Fed announcement this evening and the BoE tomorrow, there could be further downward pressure on yields if the commentary/materials from the conclusions of those meetings reflect positively on the situation in the Middle East and if members indicate they are less concerned about future inflation. In equity markets, there were further gains early on from the risk-on environment. The S&P edged back up close to a record intraday before a sell-off in the semiconductor sector turned the index around, and it lost 0.6% for the day, while the NASDAQ was off more than 1%.

ECB Chief Economist Philip Lane said yesterday that despite the Iran deal, there was inflation ‘in the pipeline’. He warned that indirect effects were still expected to feed through to prices and that the ECB saying the rate path was data-dependent was ‘not an empty phrase’. He stressed that a further hike remains possible if the data warrants it and that the hike at the meeting last week was a ‘straightforward decision’. His successor at the Central Bank of Ireland, Governor Makhlouf, backed him up, saying that ‘an end to the conflict does not necessarily mean an immediate end to the shock’ and it remains to be seen how quickly supply chains and prices react. Similarly, Bank of Spain Governor Escrivá warned that energy supply complications were likely to persist and it is not certain that markets are correctly pricing this disruption. He added that ECB policymakers do not consider the (inflation) danger to be over, and that further rate hikes could be warranted.

UK CPI inflation was steady in May coming in at 2.8% year-on-year unchanged from the April print. This is a surprise to the downside as an increase to 3.0% was the consensus forecast. Core CPI came in at 2.6% ticking up from 2.5% in April. Energy prices continue to put some upward pressure on inflation and the softer headline number this month is partly down to less of an increase in food prices. Services inflation, which the Bank of England watches closely, came in a bit higher than expected at 3.7% up from 3.2% in April and a touch above the consensus. The Bank of England MPC is widely expected to stay on hold at its meeting tomorrow and, on the face of it, this lower than expected headline number and the recent fall in wholesale energy prices reinforcing the view an immediate hike is not needed and reduces the argument for tightening policy later in the year. However, the strength, and stickiness, of services inflation as evidenced by today’s data complicates that longer term outlook somewhat as it indicates that underlying domestic inflationary pressure is still to the upside despite the more positive picture presented by the headline number.

The ZEW sentiment indicator in Germany was much more positive in June. It rose to 10.5 this month, a turnaround from the -10.2 reading in May and the first positive reading since March. The rise was all due to improving expectations as the current conditions index stayed negative and worsened to -81, from -77.8 last month. Part of the survey was conducted in recent days when the interim peace deal in the Middle East was announced, and it appears that more positive news around a potential peace deal was a driver for the improvement in expectations, with the ZEW president noting that financial market experts had been forecasting an end to the conflict and an easing in energy price pressures. The improvement was broad-based, with all sectors of the economy in the survey posting higher expectations readings than in May and most now back in positive territory.

On the agenda today, we get the final reading for Euro Area inflation for May and US retail sales, but the focus will be on the FOMC meeting decision this evening. No change in rates is virtually certain, but markets will closely watch as new Fed Chair Warsh is blooded in the press conference and see if he indicates a different tack for the committee under his leadership, as he has signaled previously that he thinks the Fed should have less forward guidance and communication. New forecasts, including updated dot plots from FOMC members, will also be released and, given events in the past few days, may show some significant changes from March’s forecasts.