Dollar Firm, Sterling Pounded Ahead of BOE Decision

February 06, 2025

Win Thin

The dollar has stabilized after yesterday’s broad sell-off; Bessent said he and Trump are focused on yields; Fed officials are finally acknowledging tariff risks; Canada highlight will be January Ivey PMI; Mexico is expected to cut rates 50 bp to 9.5%
BOE is expected to cut rates 25 bp to 4.5%; BOE will also publish its January DMP inflation expectations survey; ECB officials remain dovish; Sweden January CPI ran hot; CNB is expected to cut rates 25 bp to 3.75%
BOJ board member Tamura remains hawkish

The dollar has firmed ahead of the BOE decision. DXY is trading higher for the first time since Monday near 108. We continue to view this week’s dollar correction as a buying opportunity. The yen is the top performing major for the second straight day after hawkish BOJ comments (see below), with USD/JPY trading briefly below 152 before recovering to trade near 152.40 currently. Sterling is the worst performing major ahead of the BOJ decision (see below) and is trading lower near $1.2425, while the euro is trading lower near $1.0360 after dovish ECB comments (see below). Despite the truce in the trade war, more and more tariff noise is likely in the coming days and weeks. However, we continue to look through that noise and focus on the underlying fundamental backdrop, which remains unchanged. Simply put, the strong U.S. fundamental story of strong growth, elevated inflation, and a more hawkish Fed continues to favor higher U.S. yields and a stronger dollar. Indeed, we believe the ongoing tariff noise is keeping the Fed even more cautious. Goolsbee is one of the first to explicitly acknowledge this (see below).

AMERICAS

The dollar has stabilized after yesterday’s broad sell-off triggered in part by lower Treasury yields. The 10-year Treasury yields traded near a three-month low of 4.40% yesterday on the soft ISM services PMI (see below) but has since rebounded slightly to 4.44% today. We believe the U.S. economy remains in a good place, which should limit the downside for Treasury yields and the dollar. Ample supply of USTs should keep yields elevated as the Treasury maintained the size of next week’s quarterly refunding at $125 bln. Furthermore, it maintained its forward guidance and noted that “Based on current projected borrowing needs, Treasury anticipates maintaining nominal coupon and FRN auction sizes for at least the next several quarters.”

Treasury Secretary Bessent said he and President Trump are focused on yields. Specifically, he said “He and I are focused on the 10-year Treasury. He is not calling for the Fed to lower rates.” With inflation closer to 3% than to 2%, growth above trend, and budget deficits likely to grow, it’s hard to see UST yields going much lower. Bessent added that if “We cut the spending, we cut the size of government we get more efficiency in government. And we’re going to go into a good interest rate cycle.” Bessent also repeated his 3-3-3 economic policy mantra: boost real GDP growth to 3%, reduce the budget deficit to -3% of GDP, and increase oil production by 3 mln barrels/day.

Fed officials are finally acknowledging tariff risks. Goolsbee said that with regards to “the threat of large tariffs and the potential for an escalating trade war,” he stressed that while “These threats are not of the scale of what occurred during the pandemic but passing over their potential consequences would be a mistake.” With most other Fed officials demurring when asked about the impact of tariffs on policy, we believe that Goolsbee’s comments are the first to acknowledge those risks. Elsewhere, Barkin said “It’s very hard to know what’s happening with growth and employment, what’s happening with inflation, until you get a little more clarity on all of these uncertainties.” When asked about a potential hike, Barkin said he doesn’t take any options off the table but added “You’d have to see an economy overheating and I don’t see any signs of an economy overheating.” Waller and Logan speak today.

ADP private sector jobs estimate was strong. Headline came in at 183k vs. 150k expected and a revised 176k (was 122k) in December. Bloomberg consensus for NFP is 170k vs. 256k in December, while its whisper number stands at 199k. Both would be consistent with a healthy labor market, but we see risks of an upside surprise due to favorable readings from weekly jobless claims and other labor market indicators.

January ISM services PMI was soft. Headline came in at 52.8 vs. 54.0 expected and actual in December and nearly reverses the December gain. Activity fell to 54.5 vs. 58.0 in December and is the lowest since August, while prices paid fell to 60.4 vs. 64.4 in December. The one bright spot was employment, which rose to 52.3 vs. 51.3 in December and is the highest since September 2023. This gives us greater confidence that we get an upside surprise for NFP tomorrow.

Growth remains robust. The Atlanta Fed GDPNow model's estimate for Q1 growth is 2.9% SAAR and will be updated tomorrow after the data. The latest Q1 estimate from the NY Fed's Nowcast model stands at 2.9% SAAR and will also be updated tomorrow, while its initial forecast for Q2 growth will come in early March. The economy clearly has strong momentum going into 2025 and is another reason the Fed can remain patient.

Other key labor market data will be of interest. Q4 nonfarm productivity, unit labor costs, weekly jobless claims, and January Challenger job cuts will all be reported today. Productivity (GDP/hours worked) is expected at 1.2% q/q vs. 2.2% in Q3, while ULC is expected at 3.4% q/q vs. 0.8% in Q3. Importantly, annual productivity growth is running close to its post-war average of 2.1%. Rising productivity leads to low inflationary economic growth which translates to higher real interest rate and an appreciation in the currency over the longer term.

Canada highlight will be January Ivey PMI. Yesterday, S&P Global services PMI came in at 49.0 vs. 48.2 in December, while the composite PMI came in at 49.5 vs. 49.0 in December. Earlier this week, its manufacturing PMI fell to 51.6 vs. 52.2 in December.

Banco de Mexico is expected to cut rates 50 bp to 9.5%. However, a handful of analysts polled by Bloomberg look for either steady rates or a smaller 25 bp cut. We believe the risks of a hawkish surprise are very low as the peso has stabilized after the most recent tariff tantrum. At the last meeting December 19, the bank cut rates 25 bp but noted that “The Board expects that the inflationary environment will allow further reference rate reductions. In view of the progress on disinflation, larger downward adjustments could be considered in some meetings, albeit maintaining a restrictive stance.” The swaps market is pricing in 175 bp of total easing over the next 12 months that would see the policy rate bottom near 8.25%.

EUROPE/MIDDLE EAST/AFRICA

Bank of England is expected to cut rates 25 bp to 4.5%. The quarterly Monetary Policy Report with updated macro forecasts will be released at the same time. Most indicators of U.K. near-term activity have weakened, while services inflation cooled more than the BOE anticipated in December. There is a risk that at least one MPC member supports a larger 50 bp cut. The usual suspects that could cast a vote for a jumbo cut are Dhingra, Ramsden, and Taylor.

We expect the BOE to stick with its quantitative tightening (QT) plan. Recall that in September 2024, the MPC voted unanimously to reduce the stock of UK government bond purchases by GBP100 bln over the next 12 months to a total of GBP558 bln. There are no compelling reasons for the MPC to change gears on QT as UK 10-year gilt yields are drifting lower again and are largely guided by US 10-year Treasury yields. If we’re wrong, it would likely add to downside pressure on GBP.

Finally, we expect the BOE to maintain its policy guidance. That is, “A gradual approach to removing monetary policy restraint remains appropriate. Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term have dissipated further.” Markets are pricing in nearly 100 bp of total easing over the next 12 months, which seems about right. Governor Bailey speaks later tonight.

The BOE will also publish its January Decision Makers Panel inflation expectations survey. 1-year expectations are expected to remain steady after rising two ticks in December to a nine-month high of 3.0%. 3-year expectations rose two ticks in December to a 13-month high of 2.9%. Both series remain well above their series lows of 2.5% in October and will likely keep the Bank of England on a cautious easing path.

European Central Bank officials remain dovish. Centeno said that the bank may need to cut rates below neutral, which may be the first time an official has suggested this. We agree and have long been puzzled why officials have seemed to view the neutral rate as the floor when the economy is stagnating and likely to tip into recession. Of note, ECB staff will publish an update on the neutral rate tomorrow. The current neutral range estimate is between 1.50-3.00%. Elsewhere, Cipollone said “We all agree there is still room for adjusting rates downwards.” Despite the dovish guidance, markets are now pricing in a terminal rate of 1.75% over the next 12 months vs. 1.5% earlier this week. Vujcic and Escriva speak today.

Sweden January CPI ran hot. Headline came in at 1.0% y/y vs. 0.5% expected and 0.8% in December, while the policy relevant CPIF came in at 2.2% y/y vs. 1.6% expected and 1.5% in December. CPIF was the highest since May 2024 and back above the 2% target for the first time since then. Of note, CPIF ex-energy rose 2.7% y/y vs. 2.1% expected and 2.0% in December. The data would seem to support the Riksbank’s guidance that the policy rate would bottom at the current 2.25%. However, the swaps market is still pricing in another 25 bp of easing over the next 12 months.

Czech National Bank is expected to cut rates 25 bp to 3.75%. At the last meeting in December, the bank paused the easing cycle. However, Governor Michl has said a rate cut this week is “very likely” while board member Prochazka noted “the data we have seen so far appear to back my view that the fine-tuning process could resume as soon as in February.” The swaps market is pricing in 100 bp of total easing over the next 12 months that would see the policy rate bottom near 3.0%. Michl also plans to present a plan to the board to diversify as much as 5% of the CNB’s EUR140 bln of foreign reserves in bitcoin. Ahead of the decision, January CPI data was reported. Headline came in two ticks higher than expected at 2.8% y/y vs. 3.0% in December but remained within the 1-3% target range.

ASIA

Bank of Japan board member Tamura remains hawkish. He said “The short-term interest rate should be at the 1% level by the second half of fiscal 2025,” adding that “I think the bank needs to raise this rate in a timely and gradual manner, in response to the increase in the likelihood of achieving the price stability target.” Tamura’s comments are not surprising as he is the most hawkish board member. Indeed, he was the only one to vote in favor of a rate hike in December rather than wait until the January meeting. Markets continue to price in a terminal rate of 1.00% over the next two years. This seems about right as the BOJ expects inflation to stabilize around its 2% target in 2026. Unless we see further upward adjustment to BOJ rate expectations, JPY upside should be limited.

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