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Inflation: ‘Fed’s messaging is working,’ strategist says

DailyFX.com Senior Strategist Christopher Vecchio joins Yahoo Finance Live to discuss the state of the stock market as June ISM manufacturing data is made public, interest rates, global supply, inflation, and the outlook for Fed policy.

Video Transcript

AKIKO FUJITA: But let's move on back to the markets and the story that Brian was talking about earlier, the Fed attempting to carve a pathway that would provide a soft or somewhat soft landing for the US economy. Our next guest says Fed Chair Jay Powell's hawkish messaging is good for the US dollar, even if it means a recession. Joining us now is dailyfx.com senior strategist Chris Vecchio.

Chris, we highlighted this at the top of the show. We have seen a big pullback in yields here, the dollar coming down as well. It feels like there's been a shift in sentiment. What's driving that?

CHRIS VECCHIO: Well, I think if you look at what happens in the long end of the curve, that's where growth and inflation premiums are anticipated. And what's been happening with inflation expectations right now, they've been coming down very rapidly. Five-year, 10-year inflation swap forwards, they are at their lowest levels since October 2021.

And of course, with the recent revisions to the Atlanta Fed GDP Now growth tracker now at -1% annualized in real terms, it looks like the Fed's messaging is working. The market's expecting inflation to come back in. They're expecting a recession to arrive. Technically, NVER says it's not just two consecutive quarters, it's a protracted slowdown in growth.

We can quibble over the technical definition of recession all day long. But the fact of the matter is that the outcome that the Fed is trying to achieve, demand destruction, it's here. It's working. And that's good news for the dollar.

It's good news for the dollar because these other central banks are just not keeping up. The Bank of Japan is not doing anything anytime soon. The ECB, even as they choose to raise rates, has to pursue this quantitative easing program to prevent bond fragmentation in the fiscal situation over there in Europe. The BOE is facing a growth conundrum as well, high inflation, low growth. It looks like stagflation in the UK.

And so the Fed is just the pack leader right now, higher rates, lower rates. It doesn't really matter. The Fed messaging is far ahead of the curve.

BRIAN CHEUNG: Well, Chris, at the same time though, I'm seeing notes that have asked the question, have yields peaked in the United States? And that makes sense when you consider that you're starting to see the conversation now about Fed cuts at some point if and when this recession does happen. Now, if that is already priced into the bond market, does that imply that those interest rates differentials might actually mean that the US dollar strength has peaked as well?

CHRIS VECCHIO: It could. We're looking at the Fed funds futures curve right now, 75 basis points priced in for July, another 50 in September, November, perhaps another 25 in December. But those rate cut odds are starting to creep in for June 2023. They can't be dismissed.

At least in the near term, the dollar still has a little bit more upside. But I hear you. And I agree that there's potential for the dollar to be in the last legs of its rally here. I say that because if you take a look at futures market positioning right now, the market hasn't been this long the US dollar since March 2017. If US yields come back in on a sustainable basis, if we get a bounce in risk, that's probably going to be dollar-negative as well.

And quite frankly, even though some of this price action over the last week hasn't been that appealing, the performance of equity markets in the first half of this year was quite disastrous. There are some green shoots out there that suggest we could be turning the corner. And if we do so, that probably will be dollar-negative over the longer term, not necessarily a big turnaround in dollar-yen or euro-dollar. But this dollar climb will cease to exist.

AKIKO FUJITA: Chris, you mentioned that the Bank of Japan-- we've obviously been watching the dollar-yen cross really closely. The yen at multi-decade lows. I mean, it's traditionally been a safe haven play, right? Is that still the case.

CHRIS VECCHIO: Not in this type of environment. Not only is Japanese inflation climbing, some of the highest levels that we've seen in over five years. But they have a problem with their energy imports right now. They import over 90% of their energy, coal, oil, gas. They've shut down their nuclear power plants post-Fukushima.

And so when you have this persistent environment where natural gas prices are so high, where coal prices have skyrocketed over the past year, the best-performing space in the energy sector by the way, over the past year, and then of course, what's happened with crude oil and Brent oil, it's just bad for Japan's terms of trade. So right now, the economy already facing what you may call secular stagnation, declining population, a difficult demographic situation there. This is really the last thing that they need.

But the Bank of Japan has no choice but to try to keep rates low in order to spur some type of consumption, some type of business investment because the economy can't stand on its own two legs otherwise. BOJ now owns 50% of the JGB market. It's really incredible to see what they've done there in recent months.

BRIAN CHEUNG: Yeah. And by the way for our viewers, that's a much larger share than what quantitative easing even has done here in the United States. But Chris, I want to shift back to Europe. You outlined very nicely in the central bank story there with the BOE and the ECB. But I want to ask about the growth story, because it seems like with spreads blowing out, we know the inflation story is bad there as well.

The stagflation story in Europe is arguably something that's a little bit more pronounced than it is even here in the United States. How much of that is coming into the kind of investing strategy right now? Because it might not be a very clear-cut approach here to say, OK, well, the US growth prospects are better than Europe when both regions are kind of at risk of falling into recession here.

CHRIS VECCHIO: Both regions are at risk of falling into recession. But I agree. I think Europe, the UK, they have a higher stagflation risk than the United States. We've seen prominent people like Ray Dalio and Bridgewater take out large positions against European stocks in recent weeks, in part because stagflation is a policy conundrum.

You raise rates, you choke off growth. If you keep rates low, inflation runs away further. Even though natural gas prices have come down here dramatically over the past few days, that's more idiosyncratic, related to the news that a Freeport, rather than anything reflecting a change in a global supply picture right now. European natural gas prices continue to climb.

We're moving through the middle of the year. But once the winter months start to come into focus, the low inventories mean that there could be significant decline in growth and just a persistent high pace of inflation, 8.6% now in Europe, same level here in the United States. And obviously, we have completely different fiscal authorities. So you can't blame the administration for what's going on in Europe. But it's a problem.

The ECB has a tough task ahead of it. And as we've seen over the past decade, these core countries, your France, your Germany, your Netherlands, they prefer austerity. And I've always likened austerity-- if the patient is on the hospital bed, you don't ask for a blood donation. Going through austerity right now is really going to sink these economies in Europe in a really precipitous manner.

BRIAN CHEUNG: All right, Chris Vecchio, dailyfx.com senior strategist, thanks so much for joining us. Have a great weekend.