Dollar Firm as China and Italy Developments Sap Sentiment

August 08, 2023

Win Thin

The hawks and the doves on the FOMC continue to battle it out in public; U.S. Treasury begins its quarterly refunding; Brazil central bank minutes will be released
Italy announced a surprise windfall tax on bank profits as part of a larger package of fiscal measures; eurozone inflation expectations continue to fall; market expectations for ECB policy remain subdued
Japan reported weak June cash earnings and household spending; June current account data were also reported; China reported weak July trade data; Taiwan reported firmer July trade data

The dollar continues to recover from the post-jobs selloff. DXY is up for the second straight day and trading near 102.500 after two straight down days, and remains on track to test the July high near 103.572. The euro is trading lower near $1.0960 after Italy announced a surprise windfall tax on banks, and remains on track to test the July low near $1.0835. Sterling is trading lower near $1.2725 and remains on track to test the late June low near $1.2590. USD/JPY is trading higher near 143.15 and remains on track to test the June 30 high near 145. AUD is underperforming after China reported weaker than expected trade data. Despite the softish jobs data, we believe the relative fundamental story should continue to move in favor of the greenback. As we expected, the recent FOMC, ECB, and BOJ decisions as well as the ongoing economic data underscore the divergence theme and so further dollar gains seem likely.

AMERICAS

The hawks and the doves on the FOMC continue to battle it out in public. Fed Governor Bowman continues to push back against the dovish narrative and reiterated her view that more rate hikes may be needed. Specifically, she said that “I supported raising the federal funds rate at our July meeting, and I expect that additional increases will likely be needed to lower inflation to the FOMC’s goal.” On the other hand, New York Fed President Williams said that the need for more rate hikes is “an open question.” He added that “Monetary policy is in a good place; we’ve got the policy where we need to be.” Harker and Barkin speak today but really, it will be the data that does the talking.

The U.S. economy remains robust. The Atlanta Fed’s GDPNow model is currently tracking Q3 growth at 3.9% SAAR vs. 2.4% in Q2. Of course, that rate is likely to come down as the data come in but the strong momentum is undeniable. Next model update comes today after the data as June trade and wholesale trade sales and inventories will be reported.

The U.S. Treasury begins its quarterly refunding. The total of $103 bln will be sold this week and it begins today with a $42 bln sale of 3-year notes. At the previous auction, indirect bidders took 69.4% and the bid to cover ratio was 2.88. It continues with a $38 bln sale of 10-year notes tomorrow. At the previous auction, indirect bidders took 67.7% and the bid to cover ratio was 2.53. It concludes with a $23 bln sale of 30-year bonds Thursday. At the previous auction, indirect bidders took 69.0% and the bid to cover ratio was 2.43. The U.S. Treasury boosted its estimates for Q3 issuance to $1 trln vs. $733 bln seen back in May. The supply will remain relentless, as Treasury estimates Q4 issuance of $852 bln and so it’s hard to make a case for lower yields.

Brazil central bank minutes will be released. It just delivered a dovish surprise last week with a 50 bp cut to 13.25% vs. 25 bp expected. It said cuts of the same magnitude are likely in the coming months if the data come in as expected. Next meeting is September 20 and another 50 bp cut to 12.75% is expected. The swaps market is pricing in 100 bp of easing over the next three months followed by another 125 bp of easing over the subsequent three months.

EUROPE/MIDDLE EAST/AFRICA

Italy announced a surprise windfall tax on bank profits as part of a larger package of fiscal measures. Deputy Prime Minister Salvini announced by decree a 40% levy on windfall bank profits this year and officials confirmed that it was meant to target higher interest income due to the ongoing ECB tightening cycle. Other measures in the package will reportedly impact taxi licenses and foreign investment. However, the government has not yet published details or a text of the decree. Early estimates suggest the windfall tax could cost banks around EUR2 bln. Not surprisingly, Italian bank shares fell sharply. However, given concerns that other countries may go down this same path, the Euro Stoxx bank index is down nearly 4% on the day. As the eurozone slips into recession, banks are facing growing risks from all corners, it seems.

Eurozone inflation expectations continue to fall. According to the ECB’s monthly survey for June, inflation for the next twelve months is expected at 3.4% vs. 3.9% in May, 4.1% in April, and 5.0% in March. Looking three years ahead, expectations fell to 2.3% vs. 2.5% in both April and May and 2.9% in March. The ECB will be happy to see the drop and should allow the doves to retain control of the narrative ahead of the September meeting.

Market expectations for ECB policy remain subdued. WIRP suggest odds of a 25 bp hike stand near 35% September 14, rise to 55% October 26 and top out near 65% December 14. These odds will rise and fall with the data but Madame Lagarde clearly accentuated the negative last week and that’s what markets should focus on. What’s very interesting to us is that the ECB may stop hiking before the Fed does and we don't think the markets have priced this risk in yet.

ASIA

Japan reported weak June cash earnings and household spending. Nominal earnings came in at 2.3% y/y vs. 3.0% expected and a revised 2.9% (was 2,5%) in May while real earnings came in at -1.6% y/y vs. -0.9% expected and actual in May. This was disappointingly weak given the wage deals announced so far. With real wages still falling, it’s no surprise then that household spending came in at -4.2% y/y vs. -3.8% expected and -4.0% in May. Recent softness in the data support our view that, despite the surprise tweak to YCC last month, the Bank of Japan is in no hurry to remove accommodation.

June current account data were also reported. The adjusted surplus came in at JPY2.35 trln vs. JPY2.24 trln expected vs. JPY1.7 trln in May. However, the investment flows will be of more interest. The June data showed that Japan investors were net buyers of U.S. bonds (JPY1.8 trln) for the second straight month and five of the past six months. Japan investors remained net buyers (JPY43 bln) of Australian bonds for the fourth straight month after eight straight months of net selling, and became net buyers of Canadian bonds (JPY103 bln) after five straight months of selling. Investors turned net buyers of Italian bonds (JPY113 bln) again and have been for thee of the past four months. Overall, Japan investors were total net buyers of foreign bonds (JPY2.37 trln) for the second straight month and five of the past six months. With signs growing that the BOJ is likely to keep yields low, we expect investors to continue chasing higher yields abroad and that’s negative for the yen.

China reported weak July trade data. Exports came in at -14.5% y/y vs. -13.2% expected and -12.4% in June, while imports came in at -12.4% y/y vs. -5.5% expected and -6.8% in June. The drop in imports is particularly concerning as it suggests consumption is softening even as policymakers focus on boosting domestic demand. July CPI will be reported tomorrow. CPI is expected at -0.5% y/y vs. 0.0% in June, while PPI is expected at -4.0% y/y vs. -5.4% in June. If so, China will have entered deflation for the first time since it briefly did from November 2020-February 2021. Given the worsening economic backdrop, there is a big risk that this period of deflation will last much longer.

Taiwan reported firmer July trade data. Exports came in at -10.4% y/y vs. -20.7% expected and -23.4% in June, while imports came in at -20.9% y/y vs. -25.3% expected and -29.9% in June. Of note, chip exports came in at -6.2% y/y. This was the best showing for total exports since October but with mainland China still weakening, it’s hard to get too optimistic. Export orders remain weak and so we see little relief on the horizon for shipments.

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