Dollar Firm as U.S. Yields Rise Ahead of Key Data

July 03, 2023

Win Thin

Strong U.S. data and hawkish Fed comments last week have led to significant repricing of Fed policy; U.S. rates have reacted accordingly; ISM manufacturing PMI will be the data highlight
The rioting in France may be easing after nearly a week of violence; eurozone and U.K. reported final June manufacturing PMIs; Switzerland reported May CPI
BOJ released a strong Q2 Tankan report; Caixin reported solid June manufacturing PMI

The dollar is firm as U.S. yields rise ahead of key data. DXY is trading higher near 103.184 as strong data and heightened Fed tightening expectations continue to push U.S. yields higher. DXY has retraced nearly half of the May-June drop. Next key objective is 103.638 and a break above would set up a test of the May 31 high near 104.699. The euro is trading lower near $1.0885 while sterling is trading lower near $1.2675. USD/JPY has been unable to break above Friday’s new cycle high just above 145 on FX intervention fears. With the BOJ on hold for now, this pair should continue to march higher. With markets now starting to increasingly price in that second Fed hike this year (see below), 2-year differentials continue to move in the dollar’s direction and further gains are likely. Jobs data this Friday will be key to this repricing, though we will get plenty of other important U.S. data ahead of that.

AMERICAS

Strong U.S. data and hawkish Fed comments last week have led to significant repricing of Fed policy. A 25 bp hike in July is nearly priced in while the odds of another 25 bp hike after that have risen to around 40%. If the U.S. data continue to come in strong this week, those odds should rise further. Furthermore, Fed easing has been pushed out to next June. Simply put, the market is finally starting to believe the Fed’s “higher for longer” message. This has boosted U.S. yields and in turn this has helped the dollar get traction. The data this week will be key for an extended rally.

U.S. rates have reacted accordingly. The U.S. 2-year yield traded at a new cycle high of 4.96% today and is on track to test the March high near 5.08%. The 2-year differentials continue to move in the dollar’s favor and so we believe its recovery will continue.

ISM manufacturing PMI will be the data highlight. Headline is expected at 47.2 vs. 46.9 in May. Keep an eye on employment and prices paid, which stood at 51.4 and 44.2 in May, respectively. ISM services PMI will be reported Thursday and the headline is expected at 51.3 vs. 50.3 in May. Keep an eye on employment and prices paid, which stood at 49.2 and 56.2 in May, respectively. Last week, Chicago PMI came in at 41.5 vs. 43.8 expected and 40.4 in May. May construction spending will also be reported and is expected at 0.5% m/m vs. 1.2% in April. June auto sales will also be reported and expected at a 15.30 mln annual rate vs. 15.05 mln in May.

The U.S. economy remains strong. The Atlanta Fed's GDPNow model is currently tracking 2.2% SAAR for Q2, up from 1.8% previously. Next model update comes today after the data. It’s worth noting that after the upward revision in Q1 GDP growth to 2.0% SAAR, the economy has likely grown four straight quarters above trend at a time when the Fed wants below trend growth to bring down inflation.

EUROPE/MIDDLE EAST/AFRICA

The rioting in France may be easing after nearly a week of violence. That said, the situation remains fluid and it’s way too early to sound the all clear. The economic costs are significant and come at a time when the economy was already tipping into recession. Shopping malls, supermarkets, banks, and other businesses have all been attacked or looted during the riots. With curfews in effect, there’s no doubt that activity will take a big hit. In terms of politics, it appears President Macron may be the biggest loser even as previous protests against raising the retirement age had already left him severely weakened. Stay tuned.

Eurozone reported final June manufacturing PMIs. Headline fell two ticks from the preliminary to 43.4, Looking at the country breakdown, Germany fell four ticks from the preliminary to 40.6 and France rose five ticks from the preliminary to 46.0. Italy and Spain reported for the first time and came in at 43.8 and 48.0, respectively. Final services and composite PMIs will be reported Wednesday. Here too, Italy and Spain report for the first time and their composites are expected at 51.0 and 54.2, respectively. If so, both would be down a full point from May. The big question is whether strength in the services sector is enough to offset weakness in the manufacturing sector. We think this is unlikely as recent data suggest the eurozone is slipping into recession.

ECB tightening expectations remain steady. WIRP suggests odds of a 25 bp hike are near 90% July 27. Odds of another 25 bp hike after that stand near 60% September 14, rise to around 85% October 26, and is fully priced in December 14. After that, no more hikes are priced in. This is noteworthy as it appears the market believes the doves even though core inflation remains uncomfortably high.

The U.K. reported final June manufacturing PMI. Headline rose three ticks from the preliminary to 46.5. Final services and composite PMIs will be reported Wednesday. The economy is already slowing and the more aggressive tightening path for the Bank of England will take a toll on the economy in H2. Bloomberg consensus sees a stagnant economy in Q2 but the risks are clearly weighted to the downside.

BOE tightening expectations remain elevated. WIRP suggests another 50 bp hike is largely priced August 3, followed by 25 bp hikes September 21, November 2, and December 14 that would see the bank rate peak near 6.25%. This would represent the most aggressive tightening cycle in the majors so far in terms of absolute magnitude and yet the benefits to sterling are starting to wane. That’s because a recession is now back on the table after some earlier optimism. Updated macro forecasts will come at the August meeting and will have to acknowledge the worsening backdrop.

Switzerland reported May CPI. Headline came in a tick lower than expected at 1.7% y/y vs. 2.2% in May, while core fell a tick to 1.8% y/y. Headline was the lowest since January 2022 and now below the 2% target. The Swiss National Bank just downshifted to a 25 bp hike in June but signaled that further tightening would be needed. President Jordan said “We are not at the end - most likely there could be more rate hikes necessary in order to bring inflation on a permanent basis below 2%.” WIRP suggests a 25 bp hike to 2.0% is about 70% priced in for September 21 and remains fully priced in for December 14. The odds of another 25 bp hike after that top out near 45% in June 2024.

ASIA

Bank of Japan released a strong Q2 Tankan report. Large manufacturing index came in at 5 vs. 3 expected and 1 in Q1, while large manufacturing outlook came in at 9 vs. 4 expected and 3 in Q1. Elsewhere, large non-manufacturing index came in at 23 vs. 22 expected and 20 in Q1, while large non-manufacturing outlook came in at 20 vs. 21 expected and 15 in Q1. The pickup in large manufacturing was a bit surprising but like the rest of the world, Japan is still experiencing divergences between weak manufacturing and strong services activity. Elsewhere, final June manufacturing PMI was unchanged from the preliminary at 49.8.

Caixin reported solid June manufacturing PMI. Headline came in at 50.5 vs. 50.0 expected and 50.9 in May. Caixin reports June services and composite PMIs Wednesday. Last week, official PMIs continued to soften. Manufacturing came in as expected at 49.0 vs.48.8 in May, while non-manufacturing came in at 53.2 vs. 53.5 expected and 54.5 in May. As a result, the composite fell to 52.3 vs. 52.9 in May and was the third straight monthly drop to the lowest since December. Of note, the Caixin readings have been running higher than the official ones in recent months. Either way, there is clearly a loss of momentum in the economy and will bring forth more calls for stimulus in H2. Lastly, the PBOC has a new head in Governor Pan Gongsheng. He is well-known and well-regarded and represents continuity with outgoing Governor Yi Gang.

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