Dollar Outlook Remains Positive as New Week Begins

November 08, 2021

The U.S. Treasury will sell $56 bln of 3-year notes today; U.S. rates have fallen since the FOMC decision; Chile reported higher than expected October CPI
The ECB debate about inflation continues to rage; markets are still digesting last week’s shock decision from the Bank of England
China posted a huge upside surprise in its export figures

Measures of cross-market implied volatility picked up a bit after Friday’s strong payrolls data, but only the Treasury market MOVE index remains above its 1-year average. The MOVE index fell sharply over the previous session to around 65 after reaching the highest level since the start of the pandemic at the start of the month (78). FX vol across G7 pairs remains subdued around the 6% level, while the VIX increased slightly to around 17%, but well below its 1-year average of 22.5%.

The dollar outlook remains positive as the new week begins. After trading at a new cycle high near 94.62 Friday, DXY is on track to test the September 2020 high near 94.742. After that, there really aren't any major chart points until the June 2020 high near 97.802. A similar dynamic holds for the euro, which remains heavy after the unsuccessful test Friday of last month's cycle low near $1.1525. A clean break below would target the June 2020 low near $1.1170. The 2-year US-German differential has risen to 116 bp, the highest since March 2020, and points to further euro losses. Sterling tested its September low near $1.3410 Friday, where support held. A clean break below would set up a test of the December 2020 low near $1.3135. USD/JPY remains stuck below 114 but should eventually participate in the dollar rally as U.S. rates move higher.

AMERICAS

The case for a stronger dollar was unequivocally made last week. The Fed started tapering, the U.S. data remain strong, and the rest of the world doesn’t look so great. To top things off, Congress was finally able to pass the traditional infrastructure bill Friday, which means significant fiscal stimulus is in the pipeline now. The U.S. economy should post a strong rebound in Q4, with the Atlanta Fed’s GDPNow model tracking 8.5% SAAR growth vs. 2.0% in Q3.

With the FOMC out of the way, Fed speakers will fan out this week to spread the message. Clarida, Powell, Harker, Bowman, and Evans speak today. While the Fed has taken pains to stress that tapering does not translate to tightening sooner rather than later, the market still does not entirely believe it. The market now sees nearly 45% odds of Q2 lift-off, down from over 55% last week, while odds of Q3 lift-off have remained near 100%.

The U.S. Treasury will sell $56 bln of 3-year notes today. At the previous 3-year auction, indirect bidders took 44.2% while the bid/cover ratio was 2.36. All told, $120 bln of long-term securities will be sold this week and will be the first test for the market after tapering was announced. Will foreign demand show up? Or will investors wait for more attractive yields? More importantly, can the bond market continue to shake of higher inflation readings? The U.S. reports October PPI tomorrow and CPI Wednesday and readings are expected to remain very elevated. Stay tuned.

Paradoxically, U.S. rates have fallen since the FOMC decision. Despite the strong U.S. data reported throughout the week, yields actually ended last week significantly lower. Yes, some of this was the Bank of England effect, but that shouldn’t have long-lasting impact on U.S. rates. The U.S. 2-year yield is now trading around 0.43% after ending the week at 0.40% vs. the 0.56% peak October 28, while the 10-year yield is trading around 1.48% after ending the week at 1.45% vs. the 1.70% peak October 21. With growth strong and wages and inflation still rising, it’s hard to make a case for lower U.S. rates.

Chile reported higher than expected October CPI. Headline inflation came in at 6.0% y/y vs. 5.6% expected and 5.3% in September. This is the highest since January 2009 and further above the 2-4% target range. The central bank started the tightening cycle with a 25 bp hike to 0.75% in July, then followed up with a 75 bp hike in August and a 125 bp hike in October to bring the policy rate up to 2.75%. The last two were both hawkish surprises. Next policy meeting is December 14 and another big hike is expected then. Of note, swaps market is pricing in 275-300 bp of tightening over the next twelve months. October trade data will be reported later today.

EUROPE/MIDDLE EAST/AFRICA

The ECB debate about inflation continues to rage. ECB Chief Economist Lane stressed that the bank must not overeat to a temporary rise in inflation, adding that price pressures are expected to fall next year. He added that this current period of high inflation is very unusual and not chronic as it was in the 1970s and 1980s. Next policy meeting is December 16 and a decision on QE is expected then. If the data continue to come in weak, then the doves will have a strong case for extending QE after PEPP ends in March. Of note, swaps market is now pricing in 8 bp of tightening over the next twelve months, which is quite a turnaround from the 20-25 bp of tightening that was expected after the October 28 ECB decision.

Markets are still digesting last week’s shock decision from the Bank of England. We suspect BOE officials will continue with damage control efforts this week. Bailey speaks today. WIRP suggests close to 50-50 odds for a hike at the next policy meeting December 16, but is fully priced in for February 3. The bank will have to work hard to regain its credibility in the coming months.

ASIA

China posted a huge upside surprise in its export figures. Exports rose 27.1% y/y in October, well above the 20.3% expected, while imports disappointed at “only” 20.6% y/y. The result was a massive beat of the trade balance at $84.5 bln vs. $64.0 expected. This compares with a 5-year trade surplus average of around $40 bln. The only conclusion we can make here is that the many headwinds (energy shortage, supply bottlenecks, etc.) are being more than offset by robust external demand. On the other hand, weaker imports validate market assumptions that domestic demand is struggling to keep up. The PBOC injected another RMB 90 bln into markets today.

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