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US PPI for final demand rose 0.8% mom in May, matched expectations. For the 12-month period, PPI rose 10.8% yoy, down from April's 10.9% yoy, below expectation of 10.9% yoy. PPI less food, energy and trade services rose 0.5% mom, 6.8% yoy.

Full release here.

Summary

• Prior to Friday, June 10, we shared the universal consensus that the FOMC would hike rates by 50 bps its June 15 policy meeting. But the higher-than-expected inflation print for May now has us looking for a 75 bps rate hike.
• This expectation was reinforced by press reports on June 13 that seem designed to re-calibrate market expectations regarding the potential magnitude of the rate hike.
• We also look for a meaningful upward shift in the so-called "dot plot," which would indicate that Fed policymakers believe even more monetary tightening is appropriate in coming quarters.
• We look for the median dot to shift up to 3.375% at the end of this year and to 4.125% at the end of next year.
• We also expect the FOMC will raise its inflation forecast for 2022 while also paring down its GDP growth forecast for this year.

Source: Federal Reserve Board and Wells Fargo Economics

We Now Look for a 75 bps Rate Hike

In the preview report we wrote on June 6 that outlined our views about the June 15 FOMC meeting, we made the case for why a 50 bps rate hike was all but assured. But, that report was written before the May CPI data were released on June 10,which showed that inflation was once again higher than expected. Specifically, the overall CPI rose 1.0% in May, which boosted the year-over-year rate of inflation to 8.6% (Figure 1). Furthermore, the data were disheartening because they showed broad-base price pressures in the economy. In short, the Federal Reserve appears to be further "behind the curve" in its efforts to reduce the rate of inflation.

Consequently, we now believe it is likely that the Committee will opt to hike rates by 75 bps, which would take the target range for the fed funds rate to 1.50% to 1.75%. This expectation was reinforced by press reports on Monday, June 13 that policymakers would consider "surprising" markets with a 75 bps rate hike. Because we are now in the 10-day "blackout" period that usually precedes FOMC meetings, Fed officials are not scheduled to give any speeches. However, these press reports, which likely were confirmed by off-the-record comments by Fed officials, serve the useful purpose of re-calibrating market expectations in a rapidly changing environment.

That said, the Committee could still opt for 50 bps, although we think 75 bps is much more likely. In the event that the FOMC hikes by only 50 bps, we believe it would signal more aggressive tightening ahead via Chair Powell's post-meeting press conference and/or a significant shift higher in the so-called "dot plot."

Summary of Economic Projections: Higher Dots and Inflation, Less Growth

The dot plot (Figure 2) to be released on Wednesday likely will signal even more monetary policy tightening than we previously envisioned. In our previous FOMC preview report, we looked for the median dots for year-end 2022 and 2023 to rise to 2.875% and 3.375%, respectively. In light of last week's economic data, we now believe these projections are too low. We look for the year-end 2022 dot to be 3.375%, which would imply 175 bps of additional tightening at the four remaining FOMC meetings of the year (or 200 bps if the FOMC only hikes by 50 bps at the June 15 meeting). For 2023, we look for a year-end dot of 4.125%, which if realized would imply a target range of 4.00% to 4-25%. For 2024, we think the dot plot will signal that rates are steadily declining back toward the "neutral" rate of 2.50% or so. Accordingly, we look for the median dot for 2024 to be 3.125%.

On the inflation front, the Fed's projections will almost certainly move higher, particularly for headline inflation. Our June 8 forecast looked for the PCE deflator to increase 5.8% year-over-year in Q4 of this year, and the risks to that forecast lie to the upside after the CPI release on June 10. The median projection in the March Summary of Economic Projections (SEP) was 4.3%, and we would not be surprised if the June SEP has a median projection north of 5%. We doubt headline inflation projections for 2023 and 2024 will increase all that much as we suspect the FOMC will implicitly assume that food and energy prices decelerate and perhaps even decline somewhat in 2023 and beyond. The median projection for core PCE inflation may also tick up a tenth or two for 2022 and 2023.

Although the FOMC's projections for the federal funds rate and inflation are likely headed up, the same cannot be said for the Committee's growth forecasts. The March SEP looked for 2.8% real GDP growth year-over-year in Q4-2022, whereas our most recent forecast looks for 1.7% (Figure 3). We doubt the FOMC will revise its forecast down that much, but a median projection of between 2.0% and 2.25% seems plausible to us. The FOMC's trend-like projections for economic growth in 2023 and 2024 may fall modestly, but we doubt that they will fall substantially.

Similarly, the Fed's March projections for the unemployment rate were flat in 2022 and 2023 at 3.5%, with just a modest uptick to 3.6% in 2024. A small increase in the median unemployment rate projection strikes us as plausible for 2023 and 2024. The "longer-run" projection for the unemployment rate was 4.0% in March, so the Fed could signal slightly higher unemployment while still tacitly signaling that it believes a soft landing is in the cards.

The Japanese yen continues to drift this week. In the European session, USD/JPY is trading at 134.30, down 0.09% on the day.

All eyes on the Federal Reserve

The Federal Reserve holds its policy meeting later today. The central bank is widely expected to raise rates by 0.50% for a second straight meeting, but there are voices calling for a massive 0.75% hike, notably, the chief economist at Goldman Sachs. It would be truly shocking if the Fed delivered a 0.75% increase, given the turbulent economic environment. The financial markets are very concerned (some are calling it “panicked”) about a recession in the US. The recent US inflation report shows inflation continues to accelerate, raising doubts that an aggressive Fed can guide the economy to a soft landing and the inversion of US Treasury yields is adding to these concerns.

The US dollar enjoyed a spectacular day on Monday against most major currencies, and the dollar index surged above resistance at 105. US 10-year yields rose as high as 3.38% earlier in the day, and the upward movement continues to support the US dollar.

The Bank of Japan’s policy meeting tends to be a dull affair, but with the yen sliding lower, there is talk that the Bank could intervene aggressively on the yield curve at Friday’s meeting. The BoJ has been quick to intervene to cap JGB yields at 0.25%, and with yields breaking above this line, the BoJ may decide to respond with a change in monetary policy. The yen has lost 15% of its value this year and USD/JPY pushed above the 135 line on Monday. The BoJ and Ministry of Finance have been jawboning over the exchange rate, to little avail.

USD/JPY Technical

• USD/JPY is testing resistance at 133.68. Above, there is resistance at 1.3638
• There is support at 132.26 and 131.24

The S&P500 index fell 3.9% intraday on Monday, closing the index in the bear market territory. The Nasdaq collapsed more than 4.6%, losing a third of its all-time high in November last year.

The dollar index closed above 105 on Monday, renewing 20-year highs.

On Tuesday morning, markets are technically bouncing back after yesterday’s strong move, with index futures adding more than 1% at the start of the European trading session and the DXY retreating to 104.60.

Whether we see a double-top formation in the Dollar Index or a temporary stop before a breakout upwards, we are unlikely to know before we see the market reaction to the Fed’s Funds rate decisions and comments tomorrow evening.

The strong market movement from late last week was driven by consumer inflation, which in May hit a record since 1981, rising to 8.6% y/y. This data has triggered a wave of reassessment of the market outlook. Rate futures right now are laying down a 91% chance of a 75-point hike as early as tomorrow against a 35% chance the day before.

These are rather stressed estimates of the situation. But such a move would be too extreme for the Fed, which had previously warned that it was prepared to make several moves with a 50-point hike. In our view, the most hawkish of the realistic scenarios involves a 50-point rate hike and a hint of a 75 step up at the end of July if required.

Suppose the Fed’s tone is in line with our expectations. In that case, the dollar could retreat from its extreme valuations and a more sustained rebound in equities as the most frightening outlook for the economy recedes into the background.

However, although it will raise the rate by 50 points, the chances are high that the Fed will indicate a willingness to be more aggressive by warning of a readiness to raise the rate by 75 points in the next few meetings. Predictions about when the Fed intends to end policy tightening are equally crucial for the markets.

The markets expect the rate to peak at 4.00% in March next year from 0.75%.

Market expectations on how the Fed will act in the short and medium-term have formed an emotional bias towards excessive tightness.

However, with high and still rising inflation expectations, it may not be in the interest of the Fed to soften these expectations too much in the coming days and weeks. The latter means that the Fed could warn that it is prepared to act more firmly afterwards by keeping demand for the dollar and pressure on assets until the peak in inflation has occurred.

In an interview, RBA Governor Philip Lowe said, "Australians need to prepare for higher interest rates". He expects inflation to get to 7% by the end of the year, and "we need to be able to chart a course back to 2 to 3 per cent inflation".

Lowe said, "it's reasonable that the cash rate gets to 2½ per cent at some point... How fast we get to 2½ per cent, and indeed whether we get to 2½ per cent, is going to be determined by events."

He expects inflation to peak at around 7% in the December quarter this year. Inflation will "clearly be coming down" into the second half of next year.

Full interview here.

It has been a rough spell for the Australian dollar, which has steadied after a four-day slide. This downswing saw AUD/USD plunge over 300 points and break below the symbolic 70 level.

Market nerves weigh on the Australian dollar

Ahead of today’s FOMC rate meeting, risk sentiment is nowhere to be found. The US inflation report and expectations that the Fed will remain very aggressive have raised fears of a recession in the US. This has allowed the US dollar to surge, especially against risk-related currencies like the Australian dollar. Back in early April, AUD/USD was trading close to the 0.76 line, but the Aussie has been hammered, with drops of some 400 points in April and May.

With US inflation hitting a new 40-year high of 8.6%, some commentators are using the word “panic” to describe the financial markets. There are voices calling on the Fed to deliver a massive 0.75% hike at today’s meeting, though it would be a shock if the Fed did anything other than raise rates by 0.50%. Fed Chair Powell may use his press conference to hint at a 0.75% hike at a later date if inflation doesn’t start to fall soon, and such a message would likely boost the surging US dollar.

With no sign of an inflation peak, it’s clear that the Federal Reserve will have to keep its foot pressed to the floor when it comes to upcoming rate hikes. This makes it likely that the Fed will deliver 50-bp hikes in June, July and September. Just a couple of weeks ago the Fed signalled it would take a break in September, but that now seems a luxury it can’t afford, given that inflation continues to accelerate.

The Australian dollar didn’t get any relief from Australian releases, as NAB Business Confidence for May slowed for a second straight month, with a reading of 6 points, down from 10 previously. We’ll get a look at Westpac Consumer Confidence for June later today. The May reading came in at -5.6%, and another sharp loss could see the Aussie resume its downward movement.

AUD/USD Technical

• There is weak support at 0.6902, followed by support at 0.6765
• There is resistance at 0.6973 and 0.7110

Daily Pivots: (S1) 161.56; (P) 163.84; (R1) 165.44; More...

Intraday bias in GBP/JPY remains mildly on the downside as fall from 168.67 is in progress. Sustained break of 55 day EMA (now at 161.63) will bring deeper decline to 155.57 support. On the upside, above 165.14 minor resistance will turn bias back to the upside for 168.67 again.

In the bigger picture, up trend from 123.94 (2020 low) is still in progress. Sustained break of 61.8% retracement of 195.86 (2015 high) to 122.75 (2016 low) at 167.93 will be a long term bullish signal, and could pave the way back to 195.86 high. This will now remain the favored case as long as 155.57 support holds, even in case of deep pull back.

Daily Pivots: (S1) 138.97; (P) 140.37; (R1) 141.36; More....

Intraday bias in EUR/JPY remains mildly on the downside for 55 day EMA (now at 136.98). Sustained break there will bring further decline to 132.63 support. On the upside, above 141.77 minor resistance will turn bias back to the upside for 144.23 again.

In the bigger picture, up trend from 114.42 (2020 low) is in progress. Such rise is seen as the third leg of the pattern from 109.30 (2016 low). Sustained trading above 100% projection of 114.42 to 134.11 from 124.37 at 144.06 will indicate upside acceleration and target 149.76 long term resistance (2014 high). In any case, outlook will now remain bullish as long as 132.63 support holds, in case of deep pull back.

Daily Pivots: (S1) 0.8542; (P) 0.8568; (R1) 0.8604; More...

Intraday bias in EUR/GBP remains neutral with focus on 0.8617 resistance. Firm break there will resume rise from 0.8201 medium term bottom to 0.8697 medium term fibonacci level. In any case, further rally will remain in favor as long as 0.8365 support holds.

In the bigger picture, a medium term bottom could be in place at 0.8201, on bullish convergence condition in daily and weekly MACD. Rise from there could either be a correction to the down trend from 0.9499 (2020 high), or a medium term up trend itself. In either case, further rise should be seen to 38.2% retracement of 0.9499 to 0.8201 at 0.8697. Sustained break there will target 61.8% retracement at 0.9003.

Daily Pivots: (S1) 1.4940; (P) 1.4997; (R1) 1.5087; More...

Intraday bias in EUR/AUD is back on the upside as rebound from 1.4758 resumes. Further rally would be seen to retest 1.5277 resistance first. Break there will target 1.5354 support turned resistance next. On the downside, below 1.4966 minor support will turn intraday bias neutral again.

In the bigger picture, as long as 1.5354 support turned resistance holds, larger down trend from 1.9799 (2020 high) is still expected to continue. On resumption, next target is 61.8% projection of 1.9799 to 1.5250 from 1.6434 at 1.3623, which is close to 1.3624 long term support (2017 low). However, firm break of 1.5354 will indicate medium term bottoming and bring stronger rally back to 1.6434 key resistance.