Dollar Bid Amidst Global Bond Rout

October 18, 2021

Global bond markets are finally waking up to the risks that inflation isn’t as transitory as most central banks insist; if inflation risks continue to rise, which central banks are best positioned to respond; is the market overreacting; U.S. September IP will be the data highlight
Market pricing of BOE tightening has gone parabolic; surprisingly, sterling has yet to react
New Zealand reported higher than expected Q3 CPI; China data came in on the weaker side of expectations

The dollar is getting some traction during this global bond rout. DXY is up today just above 94 and follows three straight down days after posting a new cycle high near 94.56 last week. USD/JPY remains bid, trading just below October 2018 high near 114.55. After that is the November 2017 high near 114.75. Elsewhere, the euro remains heavy as it failed again to gain traction above $1.16. Sterling saw no follow-through after breaking above $1.3720 last week, which is where it sits now. With the Fed ready to taper, markets fully pricing in Q3 22 Fed liftoff, and price pressures still rising, we believe this move higher in U.S. rates and the dollar has legs.

AMERICAS

Global bond markets are finally waking up to the risks that inflation isn’t as transitory as most central banks insist. The ostensible sparks were higher than expected New Zealand CPI and hawkish BOE comments (see below), but the tinder has been long building. At the long end, 10-year yields are up across the board, led today by New Zealand (+16 bp), Australia (+9 bp), Italy (+7 bp), U.K. (+6 bp), Canada (+5 bp), and the U.S. (+5 bp). At the short end, rates are also up across the board, reflecting heightened risks that policy makers will have to respond. Here, the move is led today by New Zealand (+24 bp), U.K. (+14 bp), Germany (+6 bp), Italy (+5 bp), the U.S. (+5 bp), and Canada (+4 bp).

If inflation risks continue to rise, which central banks are best positioned to respond? The RBNZ and Norges Bank have already started tightening. BOE seems next in line to hike (see below), while the Fed is likely to begin tapering next month. The Fed Funds futures strip has gotten much more aggressive about lift-off. Q3 22 lift-off is nearly fully priced in, up from about 50% at the start of last week. Another hike in Q4 lift-off is nearly fully priced in too. BOC sees lift-off in H2 22, while RBA sees lift-off in 2024 at the earliest. Of note, the ECB, BOJ, SNB, and Riksbank show no intent to hike rates before 2024 or 2025 at the earliest.

Is the market overreacting? Probably. However, we have long felt that the markets were underreacting to what we saw as serious inflation risks. The truth is probably somewhere in between. Central banks may have to respond to the threat, but probably not to the extent that markets are pricing in. This debate will likely take weeks, if not months, before some sort of true conclusion can be reached. However, we are confident that U.S. rates and the dollar will continue rising throughout this debate.

U.S. September IP will be the data highlight for the day. It is expected to rise 0.2% m/m vs. 0.4% in August. We get lots of U.S. manufacturing data this week. Fed regional surveys will continue to roll out with Philly Fed reporting Thursday, which is expected at 25.0 vs. 30.7 in September. Markit preliminary October PMI readings will be reported Friday. Manufacturing PMI is expected at 60.5 vs. 60.7 in September, while services PMI is expected at 55.2 vs. 54.9 in September. The composite PMI stood at 55.0 in September. August TIC data will also be reported. Quarles and Kashkari speak.

EUROPE/MIDDLE EAST/AFRICA

Market pricing of Bank of England tightening has gone parabolic. This latest move is due to Governor Bailey’s comments over the weekend saying the BOE will have to act on inflation, which led the 2-year gilt yield to spike to 0.75%, nearly double the 0.38% yield at the start of October. The short sterling strip is fully pricing in Q4 lift-off, followed by another four hikes in 2022. Indeed, WIRP suggests a hike at the November 4 meeting is almost fully priced in, followed by nearly 50% odds of another hike at the December 16 meeting.

Surprisingly, sterling has yet to react. The 2-year gilt spread to the U.S. has risen to a new cycle high near 28 bp , which should give cable some support. Sterling is outperforming but it is still down -0.2% on a day when the dollar is bid across the board. Kiwi is also lower despite heightened RBNZ tightening expectations (see below) and this supports our view that it’s all about the Fed right now. Tightening by other central banks may lend their currencies some support, but it’s still King Dollar for now.

ASIA

New Zealand reported higher than expected Q3 CPI. Headline inflation accelerated to 4.9% y/y vs. 4.2% expected and 3.3% in Q2. This was the highest since Q2 2011 and moves further above the 1-3% target range. No wonder the market is pricing in further hikes by the RBNZ after it started the tightening cycle last week. WIRP shows a 25 bp hike to 0.75% is fully priced in for the November 24 meeting, with 50% odds of a 50 bp move then. Looking ahead, 25 bp hikes are priced in for the February 23, April 13, and May 25 meetings that would take the OCR up to 1.75%. Kiwi and Aussie bond yields rose to 10-year highs, dragging NZD and AUD to session highs near .7105 and .7440, respectively.

China data came in on the weaker side of expectations. Q3 GDP rose 0.2% q/q vs. 0.4% expected and rose 4.9% y/y vs. 5.0% expected. Retail sales were stronger than expected at 4.4% y/y but industrial production was weaker than expected at 3.1% y/y. Base effects played an important role here, but the slowdown is more fundamental. China will be up against a series of headwinds including shortages of components (microchips), electricity outages, the impact from tighter regulatory scrutiny (especially on the real estate sector), and the fallout from the delta variant. All of these factors will weigh on China’s data for the rest of the year, though attenuated by policy support.

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