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All Eyes on US Inflation

US equities fell, while yields pushed higher in the run up to today’s most important US inflation data. Inflation in the U.S. is expected to have rebounded from 3 to 3.3% in July and core inflation may have steadied at around 4.8%. Any bad surprise on the inflation front could revive the Federal Reserve hawks, but we are far from pricing another hike in September just yet; activity on Fed funds futures assesses more than 85% chance for pause in September FOMC meeting. Rising oil, crop and rice prices are the major upside risks, while potential downside pressure on shelter could counter higher raw material prices. According to a latest publication from SF Fed shelter prices could see significant disinflation or deflation in the months ahead. They wrote that their ‘baseline forecast suggests that year-over-year shelter inflation will continue to slow through late 2024 and may even turn negative by mid-2024’, and that we could see ‘the most severe contraction in shelter inflation since the Global Financial Crisis of 2007-09’.

The idea of further Fed hikes is not helping sentiment in bond markets, especially since Fitch downgraded the U.S. credit rating from AAA to AA+. That’s bad news for two reasons. First a lower credit rating means that the US should compensate for the higher risk investors take while buying the US government bonds so it’s an additional upside pressure on yields. And combined to Fed hikes, the US interest payments will become an increasingly growing burden. In numbers, the US spends $1.8 bn interest payments every day. According to Peter Peterson foundation this number will double in the next decade and interest payments will become the fastest growing part of the federal budget. And if that’s not enough, Moody’s downgraded credit ratings for 10 small and midsize US banks, citing higher funding costs, potential regulatory capital weaknesses and risks tied to commercial real estate loans. And speaking of banks, Italian banks also sold off earlier this week on news of a new windfall tax. The latter triggered some risk averse inflows into bonds until Italy issued a clarification of its new tax on banks’ windfall profits, saying that the impact may be limited for some banks and the levy won’t exceed 0.1% of a firm’s assets. Banks that have already increased the interest rates they offer to depositors ‘will not have a significant impact as a consequence of the rule approved yesterday’. Phew….

The U.S. 2-year yield rebounded past 4.80%, while the 10-year yield is back to around%, after a spike to 4.20% on Fitch downgrade.

Troubled China

Chinese indices are up and down. Up, thanks to measures that the Chinese government announced to support the economy, down because of plunging export/import, deflation worries following another round of soft trade, CPI and PPI numbers since the start of the week, and the jitters that the US could limit investments to China. One interesting point is that the Chinese stock market shows decorrelation from the stock markets of developed countries. KraneShares CSI China Internet ETF saw $342.23 million inflows last week, the biggest weekly inflow in 14 months. Yet impressive growth numbers are probably not in China’s near future as the population is shrinking, the real estate crisis fuels the local debt crisis with Country Garden’s potential default on its debt now making the headlines, investor and consumer confidence in Chinese government will take time to be restored, and further restrictions of US investments in China, especially in cutting-edge sectors like AI and quantum computing could further dampen appetite.

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