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NZD underperforms despite another upside surprise to NZ CPI inflation

There hasn’t been a major theme to market movements overnight, with investors awaiting the big event risks in Europe later this week.  US equities are now slightly lower on the session, the US 10-year rate is slightly higher, while commodities have rebounded from their recent slump, helped by a weaker USD.  Ahead of these key upcoming European risk events, the EUR has rallied strongly, hitting a high of 1.02.  The NZD got an initial boost from yesterday’s higher-than-expected CPI release, but the reaction has since faded, and it is now little changed from the end of last week.  The NZ rates market is now pricing a slightly better-than-even chance of a 75bps RBNZ hike next month.

Europe is in focus this week, for a change, with several potentially market-defining events on the calendar, namely the end to the annual maintenance period for the Nord Stream 1 gas pipeline, the ECB meeting, and Italian PM Draghi’s decision on whether to resign.  European markets have started what is a pivotal week on a relatively positive note, with the EuroStoxx 600 index up almost 1% and the EUR appreciating 0.7% to around 1.0150, having earlier briefly touched 1.02.

Helping sentiment towards Europe, Bloomberg reported that a group of MPs from the Five Star party in Italy was trying to salvage the coalition government led by Draghi.  Last week, Five Star leader Conte said his party was pulling out of the coalition, prompting Draghi to offer his resignation and throwing Italy into fresh political turmoil, but it appears some of Conte’s own MPs are trying to keep the government together.  Draghi is due to announce whether he will stick with his resignation decision on Wednesday night.  He has previously said he would not continue as PM if he did not have the support of parliament.  The market reacted positively to the news, with the Italy-Germany 10-year bond spread falling 6bps, albeit to a still-high 206bps.

In other European news, Gazprom, the Russian state energy giant, declared force majeure on its gas contracts with several European customers dating back to 14 June.  Gazprom has previously blamed problems getting a Siemens turbine fixed as the reason why gas flows through the Nord Stream 1 pipeline dropped 60% ahead of the annual maintenance period.  The key focus for the market is whether gas flows to the continent substantively resume when the annual maintenance period ends on 21 July, with Bild reporting the German government expects Putin to hold back supplies, in turn restricting the ability of European countries to build storage levels ahead of winter, to inflict more economic damage on Europe.  European natural gas futures were little changed on the day, suggesting the market didn’t see the Gazprom news as providing much of a signal as to whether gas flows will or will not resume from later this week.

US equities opened higher overnight, with consensus building that the Fed will restrict itself to hiking 75bps at next week’s meeting, rather than 100bps.  However, US markets have given back those gains over the past few hours to now be slightly lower on the day (S&P500 and NASDAQ -0.4%).  A Bloomberg report that Apple would slow hiring and spending in some parts of its business next year (in response to what are expected to be more challenging economic conditions) appeared to prompt the reversal in equities.  Several other tech firms, including Tesla and Meta, have announced hiring freezes or layoffs over recent months.

There have been strong earnings results from the major US banks overnight, with Goldman and Bank of America both beating market expectations for revenue and earnings, the latter benefiting from the higher interest rate environment with stronger net interest income.  Goldman’s share price was up 2% overnight while Bank of America’s was little changed.  IBM is due to report after the bell this morning.

There hasn’t been much economic data overnight, just the US NAHB housing index which slumped to 55, its lowest level in seven years (excluding early 2020).  The decline in homebuilder sentiment is unsurprising considering the significant increase in US mortgage rates and increase in costs of building.

Global rates are higher overnight, led by the moves in Europe, with the German 10-year rate increasing 8bps, to 1.22%.   The US 10-year rate was up by as much as 10bps at one point, breaching the 3% mark, but is has since eased back to 2.96%.  Long-term rates look like they are in a choppy trading range for now, centred around 3% on the US 10-year.  Market expectations for the upcoming Fed meeting appear to have settled, with the consensus now that the Fed will hike by 75bps and only around a 20% chance of a 100bps hike priced in.

After its recent strong run, the USD is broadly weaker overnight, the BBDXY index falling 0.5% for the second day running.  Partly this appears to reflect slightly less negativity towards Europe and the EUR, although it could be just as much investor profit-taking after what has been a big move higher in the USD.  Commodity currencies have underperformed, despite a rebound in commodities to start the week (oil +4.9%, copper +3.3%).  The CAD is 0.5% higher and the AUD is up 0.4%, while the NZD is at the bottom of the currency leader board, largely unchanged since the end of last week despite yesterday’s upside surprise to NZ CPI.

Continuing the run of upside inflation surprises, NZ Q2 CPI came in higher than expected, with annual inflation hitting a more-than 30-year high of 7.3% (7.1% expected).  While the RBNZ had alluded to “near-term upside risks” to CPI at its meeting last week, what will be less comforting is that the upside surprise was clearly driven by the non-tradables (i.e. domestic) component, which picked up to 6.3%, in contrast to the RBNZ’s MPS forecast of 5.7%.  Likewise, the core inflation measures were higher across the board, symptomatic of strong underlying inflationary pressures.  CPI excluding food and energy hit 6.1% while the RBNZ’s Sectoral Factor Model reached an all-time high of 4.8%, up from an upwardly revised 4.6% in Q1. We have cautiously pencilled in this being the peak in annual headline inflation and we expect some moderation in the coming quarters, although it is likely to be some time before inflation is back within the RBNZ’s 1-3% target range.

The immediate market reaction saw domestic interest rates and the NZD spike higher before a reversal set in over the course of the day, with the market likely already conditioned for a strong number.  By the end of the day, the market had moved to price a slightly better-than-even chance of a 75bps RBNZ hike at the August MPS and a terminal OCR of around 4.10%.  The 2-year swap rate was 6bps higher on the day, at 4.11%, while longer-term rates were less moved, the 10-year swap rate only 1bps higher.  The net result was a further inversion in the yield curve, with the 2y10y swap curve reaching -26bps, its lowest level since 2008.  The inverted yield curve is consistent with the market seeing the RBNZ overtightening over the next 12 months and eventually needing to reverse course.

Likewise, the NZD spiked to as high as 0.62 in the wake of the CPI surprise before easing back to 0.6160, unchanged from the end of last week despite a broadly weaker USD.  While the upside inflation surprise implies the risk of more aggressive RBNZ tightening, global headwinds for the NZD remain formidable, including the growing risk of a global recession, the Fed’s aggressive rate hike intentions, and the unfolding energy crisis in Europe, which is weighing on the EUR (and by extension, the NZD).  The potential for more aggressive RBNZ tightening also points to greater downside risks for the NZ economy.

The session ahead sees a speech from RBA Deputy Governor Bullock, who is likely to be quizzed on whether the central bank will consider a 75bps hike next month (Governor Lowe is also speaking tomorrow).  Bank of England Governor Bailey is also speaking.  

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