Dollar Continues to Drift Lower Ahead of FOMC Decision

September 20, 2023

Win Thin

The Fed is expected to deliver a hawkish hold; the Dot Plots will be very interesting; Canada August CPI data offer a cautionary tale for central banks; BOC releases the summary of its deliberations; Brazil COPOM is expected to cut rates 50 bp to 12.75%
U.K. reported soft August inflation data; the data lowered BOE expectations for tomorrow
Yen jawboning has picked up; Japan reported August trade data; New Zealand reported Q2 current account data; China banks kept their LPRs steady, as expected; Taiwan reported soft August export orders

The dollar continues to drift lower ahead of the FOMC decision. DXY is trading marginally lower for the fourth straight day near 105 after three straight up days took it up to the highest since March 9 near 105.435 last Thursday. If the Fed delivers as we expect, DXY should get back on track to move above last week’s high. The euro is trading higher near $1.07 but remains on track to test and eventually break below last week’s low near $1.0630. Sterling traded as low as $1.2335 after lower than expected CPI data (see below) but has since recovered to trade near $1.2370. We believe cable remains on track to break below the May low near $1.2310. USD/JPY traded at a new cycle high near 148.15 but has reversed on some official jawboning. With the BOJ expected to deliver a dovish hold Friday, we believe the pair remains on track to test 150. The fundamental story remains in favor of the greenback as the U.S. economy is in a much stronger position than the other major economies such as the eurozone or the U.K. Indeed, the worsening outlook in Europe led the ECB to deliver a dovish message last week and we believe the BOE will follow suit tomorrow. With firm U.S. data and a hawkish Fed, this should feed into further dollar strength.

AMERICAS

The two-day FOMC meeting ends with a decision this afternoon. We expect a hawkish hold. Recent data have been mixed enough for the Fed to feel comfortable with another skip and WIRP suggests basically zero odds of a hike today. Most likely, we will see the next hike November 1. By that November meeting, we will get one more each of the jobs report, CPI, PPI, and retail sales as well as two PCE readings. If things continue the way we expect for the U.S. economy, the current 30% odds of a hike then are way too low.

We believe the Fed will be sufficiently hawkish so that markets don’t think it is done hiking. When all is said and done, headline inflation is creeping up towards 4% while core remains stuck near 4%. The economy is still growing above trend and the labor market remains extremely tight. Financial conditions are the loosest since early March 2022, before the Fed started hiking. Simply put, current conditions warrant further tightening. Canada CPI data yesterday (see below) should get the Fed’s attention.

Fed Chair Powell must be resolute at his press conference. At the June press conference, he stayed on message and stressed that the Fed hasn’t made a decision to hike at every other meeting, adding that it would hike in September if the data warranted. We expect him to repeat this message. Powell said the slowdown in June CPI was welcome but stressed it was only one month. This was prescient, as July and August data showed. He said the Fed needs to stay “on task” and that the Fed needs to hold rates “for some time.” We expect him to again stress this higher for longer message.

New macro forecasts will be released. Note that 2026 will be added to the forecast horizon. In light of the recent data, we expect the growth and inflation forecasts to be revised up and the unemployment forecasts to be revised down. Current Bloomberg consensus for GDP growth stands at 2.0% in 2023, 0.9% in 2024, and 1.9% in 2025, while consensus for PCE stands at 3.7% in 2023, 2.4% in 2024, and 2.2% in 2025.

The Dot Plots will be very interesting. In the June Dot Plots, the median 5.625% rate seen at end-2023 suggests one more hike this year. This should stay the same because if the Fed hikes in November as we expect, we very much doubt that it will hike again in December as it sticks with its skip pattern. The fact that the Dot Plots are for year-end rates masks the possibility that the Fed could hike one more time in early 2024 and then cut by end-2024 to end up with lower rate than end-2023. Either way, we see a hawkish shift up for end-2024 and end-2025 to perhaps 5.125% and 4.125% from the current 4.625% and 3.375%, respectively. Fed Funds futures are currently pricing in an end-2024 rate around 4.735% and an end-2025 rate around 4.31% and so a hawkish shift in the Dot Plots should lead to some market repricing.

Canada August CPI is worth discussing. Headline came in at 4.0% y/y vs. 3.8% expected and 3.3% in July. Inflation accelerated for the second straight month to the highest since April and further above the 2% target. Elsewhere, core trim came in two ticks higher than expected at 3.9% y/y vs. 3.6% in July, while core median came in at 4.1% y/y vs. 3.7% expected and a revised 3.9% (was 3.7%) in July. The data show that it’s not just energy that’s an issue here, as the core measures are also turning higher.

Recall that the BOC paused its tightening cycle after hiking rates 25 bp to 4.5% on January 25. That pause lasted for the March 8 and April 12 meetings but then the BOC delivered a hawkish surprise June 7 by unexpectedly restarting the tightening cycle with a 25 bp hike to 4.75%. It followed up with another 25 bp hike to 5.0% July 12 and then paused again at the September 6 meeting. It appears that the BOC has twice been lulled into a sense of complacency and as a wise man once said, “Fool me once, shame on me. Fool me twice, won’t get fooled again.”

BOC tightening expectations have adjusted higher. Before the CPI data, WIRP had 25% odds of a hike at the next meeting October 25. Now, those odds are nearly 50% and rise to 80% December 6 and fully priced in for January 24. There are even 10% odds of a second hike in March.

Bank of Canada releases the summary of its deliberations. After yesterday’s CPI surprise, the summary has taken on greater significance and will be scoured for clues for what might trigger another hike this year. At the September 6 meeting, the bank kept rates steady at 5.0% but the message was hawkish. It remained “concerned” about sticky inflation and is prepared to hike again if needed. The bank said the hold was driven by signs that excess demand was easing as well as the expected lagged impact of past tightening. It noted that the labor market was easing gradually but that wage growth remains high.

This is a cautionary tale for central banks around the world. Like the U.S., Canadian headline and core inflation are in the 4% range and rising. We believe policymakers and markets everywhere have gotten too complacent about inflation risks, even before this latest spike in oil prices. Now, those risks are impossible to ignore and central banks must acknowledge the possibility of further tightening. Today would be a good time for the Fed to lead by example.

Brazil COPOM is expected to cut rates 50 bp to 12.75%. Since the easing cycle started August 2, inflation has accelerated two straight months. This was due largely to low base effects in July and August and likely to persist in September, and so the central bank is looking through it. The swaps market is pricing in 150 bp of total easing over the next three months followed by another 100 bp over the subsequent three months.

EUROPE/MIDDLE EAST/AFRICA

U.K. reported soft August inflation data. Headline CPI came in at 6.7% y/y vs. 7.0% expected and 6.8% in July, core came in at 6.2% y/y vs. 6.8% expected and 6.9% in July, and CPIH came in at 6.3% y/y vs. 6.6% expected and 6.4% in July. This continues the deceleration in headline to the lowest since February 2022 but remains far above the 2% target. However, RPI picked up a tick to 9.1% y/y.

The data lowered Bank of England expectations for tomorrow. WIRP suggests odds of a 25 bp hike are now less than 50% vs. 85% at the end of last week. For a time over the summer, a 50 bp hike was largely priced in and so the change is noteworthy. There are no longer any odds of a second 25 bp hike and so the bank rate is likely to top out at 5.5% vs. the 6.5% peak that was priced in over the summer. We fully expect a dovish message from the BOE, similar to what we got from the ECB last week. The first cut is still not priced in until H2 2024 but that is of course subject to change.

ASIA

Yen jawboning has picked up. Treasury Secretary Yellen of all people opened the door, noting that BOJ intervention would be understandable if it were meant to address excessive volatility. However, she qualified her statement by adding “It would depend very much on the details. We usually communicate with them about these interventions.” Top Japan currency official Kanda later said “We maintain extremely close communication with foreign authorities, especially the United States, on a regular basis.” Kanda said he wouldn’t rule out any market actions if needed and stressed that he continues to monitor developments with an “extreme sense of urgency.”

USD/JPY traded above 148 today for the first time since November. It made new high for this move near 148.15 but has since fallen back to trade around the 148 figure. With the Fed expected to deliver a hawkish hold and the BOJ a dovish hold, the monetary policy divergences remain in play and the pair remains on track to test the October cycle high near 152. Sporadic jawboning may lead to some knee-jerk reversals but the uptrend is likely to remain intact until either the Fed or BOJ pivots and we’re not there yet.

Japan reported August trade data. Exports came in at -0.8% y/y vs. -2.1% expected and -0.3% in July, while imports came in at -17.8% y/y vs. -20.0% expected and -13.6% in July. Exports contracted in back-to-back months for the first time since late 2020.

New Zealand reported Q2 current account data. The deficit came in at -7.5% of GDP vs. -8.0% expected and a revised -8.2% (was -8.5%) in Q1. This was the second straight quarter of improvement from the -9.0% peak in Q4 2022 and the lowest since Q1 2022. Unfortunately, the narrowing deficit is due in large part to the economic slowdown.

China banks kept their Loan Prime Rates steady, as expected. The 1- and 5-year rates were kept steady at 3.45% and 4.20%, respectively. After the PBOC cut reserve requirements last week, however, it’s clear that monetary stimulus remains ongoing and we look for further easing in Q4. Indeed, senior PBOC official said the bank has “ample policy room” and that it will step up its counter-cyclical policy stance. Recent data suggest the economy is starting to respond to stimulus but it’s way too early to say that it has bottomed. Here too, monetary policy divergences are still widening and argue for a weaker yuan.

Taiwan reported soft August export orders. Orders came in at -15.7% y/y vs. -11.4% expected and -12.0% in July. Korea reports trade data for the first twenty days of September tomorrow. While the worst may be over for regional activity, we do not expect a sharp rebound anytime soon and instead look for a period of bouncing along the bottom.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2022. All rights reserved.