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Marketmind: China factory fright, dollar surges

FILE PHOTO: Illustration shows U.S. dollar banknotes

A look at the day ahead in U.S. and global markets from Mike Dolan

With the U.S. debt ceiling saga nearly over, the state of the global economy hoves back into view - with contrasting interest rate pictures that saw the dollar climb across the board.

A deepening contraction of Chinese factory activity this month casts more doubt over the spluttering recovery of the world's second largest economy, while Europe saw some inflation relief as French and German readouts for May mirrored the surprising drop in Spanish inflation seen earlier this week.

China's official manufacturing purchasing managers' index unexpectedly fell to 48.8 from 49.2 in April, staying below the 50-point mark that separates expansion from contraction and below a forecast of 49.4.

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The yuan, now down more than 3% from its early May peaks, skidded to its lowest level of the year against the dollar as investors considered the possibility of further credit easing by the Chinese central bank.

With Federal Reserve officials increasingly hawkish about another U.S. interest rate rise in June and Congress finally on its way this week to lifting the debt ceiling for two years, the dollar was pumped up across the board.

Cleveland Fed President Loretta Mester told Wednesday's Financial Times she saw no "compelling reason" for the central bank to pause its rate hike campaign next month, emboldening futures markets that now see a 65% chance of another quarter point rise in two weeks time.

The dollar index hit its highest level since mid-March, with the European inflation news and China demand picture knocking the euro to its lowest in two months too.

Although Italy bucked the trend of downside inflation surprises, the overall price picture encouraged markets to believe the European Central Bank may be less than half a percentage point from a peak policy rate around 3.6% - about 170 basis points below where it now sees the Fed's "terminal rate".

Also pressured by the Chinese news, crude oil prices are now falling at an annual rate of more than 40% for the first time since the depth of the pandemic in June 2020. Euro zone natural gas prices are at their lowest in almost two years.

German import prices fell at an annual rate of 7% in April and the ECB's financial stability report warned about a "disorderly" hit to house prices from higher mortgage rates.

For the Fed, the week's key take will be from the domestic labour market - with April job openings data due later on Wednesday ahead of Friday's May employment report.

With the House of Representatives now likely to vote on a bill to lift debt ceiling as soon as Wednesday, it appears that drama is subsiding at last.

The House Rules Committee voted 7-6 on Tuesday to approve the rules allowing a debate and vote by the full chamber.

One-month Treasury bill yields have returned close to normal levels, with two-year Treasury yields slipping back below 4.4%.

Overall, stock markets slipped back slightly - with Hong Kong's Hang Seng index the big underperformer after the Chinese factory release.

U.S. stock futures were marginally in the red ahead of the open.

Events to watch for later on Wednesday:

* U.S. April JOLTS job openings data; May MNI Chicago purchasing managers survey, Dallas Fed May service sector survey.

* Federal Reserve releases Beige Book of economic conditions

* Federal Reserve Board Governor Philip Jefferson, Boston Fed President Susan Collins, Philadelphia Fed chief Patrick Harker speak; European Central Bank President Christine Lagarde speaks

* House of Representatives likely to vote on bill to lift debt ceiling

* U.S. corporate earnings: NetApp, Salesforce, Advance Auto Parts, Crowdstrike

(By Mike Dolan, editing by Jane Merriman mike.dolan@thomsonreuters.com. Twitter: @reutersMikeD)