Dollar Rally Continues as U.S. Returns from Holiday

October 12, 2021

U.S. rates continue to rise; Treasury has a heavy auction schedule this week; Fed speakers are plentiful; the House is scheduled to vote on the short-term extension of the debt ceiling today
Germany reported September WPI and October ZEW survey; Brexit tensions are heating up; U.K. began its monthly data dump; short sterling strip continues to price in an aggressive BOE tightening cycle; there seems to be no end to market-negative headlines from Turkey, with the latest being the risk of military action in Syria
China’s regulatory eye has turned back to financial institutions; Korea kept rates on hold at 0.75% as expected, but more tightening is on the way; more flooding in China led to a spike in coal futures to another record high

The dollar is consolidating its recent gains. DXY is up for the second straight day near 94.35 as U.S. rates continue to rise. Right now, it’s all about the yen. USD/JPY traded today at the highest level since December 2018 near 113.50. The November 2018 high near 114.20 is the next target, followed by the October 2018 high near 114.55. Elsewhere, the euro remains heavy near $1.1555 after trading last week at the lowest level since July 2020 near $1.1530. Sterling is holding up relatively better near $1.36 but the negatives (weak data, Brexit tensions, energy crisis) continue to pile up and so we see a period of underperformance ahead. If U.S. data this week point to continued strength in the economy, rates and the dollar should continue to move higher.

AMERICAS

The U.S. returns from holiday today. Yields are making new highs for this move and data this week will be key in extending this move. We continue to believe the Fed will announce tapering at the November 2-3 FOMC meeting. In the past, such tapering has led to further dollar gains and we believe that dynamic will continue to play out in the coming weeks. Please see our recent piece “Tapering and the Dollar.” While the Fed has taken pains to separate tapering from tightening, it’s impossible to disentangle the two. According to the Fed Funds futures strip, Q4 22 lift-off is fully priced in, while odds for Q3 22 lift-off have risen to nearly 55%, which are quite significant indeed.

U.S. rates continue to rise. The 10-year yield traded today at 1.63%, the highest since June 4 and on track to test the May high near 1.70%. After that is the March high near 1.77%. Elsewhere, the 2-year yield traded today at 0.35%, the highest since late March 2020. This suggests an accelerated timeline for lift-off and of course, this has implications for the dollar, which remains on a tear. The 2-year differentials with Germany (102 bp) and Japan (45 bp) are both at cycle highs and support further dollar gains vs. the euro and yen.

The U.S. Treasury has a heavy auction schedule this week. $58 bln of 3-year notes and $38 bln of 10-year notes will be auctioned today. At the previous auction, indirect bidders took 56.7% and 71.1% and the bid-cover ratios were 2.45 and 2.59, respectively. A $24 bln sale of 20-year bonds will be held tomorrow. At the previous auction, indirect bidders took 69.7% and the bid-cover ratio was 2.49. Will foreign buyers participate with yields on the upswing? Stay tuned.

Fed speakers are plentiful. Clarida, Bostic, and Barkin speak today. The large group of speakers this week includes both hawks and doves and so it will be very important to see how the Fed is interpreting Friday’s jobs report. August JOLTS jobs openings are expected at 10.954 mln vs. 10.934 mln in July. If so, this would be another record high and would support the view that weak jobs numbers are due to supply, not demand.

The House is scheduled to vote on the short-term extension of the debt ceiling today and it is widely expected to pass. Then comes the hard part: getting the Democrats to compromise amongst themselves on the “human infrastructure” bill. We think it will happen, which should then see it and long-term debt ceiling extension or suspension passed together via budget reconciliation. After that, the traditional infrastructure bill should be passed by a bipartisan vote.

EUROPE/MIDDLE EAST/AFRICA

Germany reported September WPI and October ZEW survey. WPI rose 13.2% y/y vs. 12.3% in August and continues to make new all-time highs. Of course, this warns of strong pipeline pressures that are likely to make their way into CPI, which was also at a record high 4.1% y/y in September. ZEW survey fell sharply in October, with expectations falling to 22.3 vs. 23.5 expected and 26.5 in September and current situation falling to 21.6 vs. 28.0 expected and 31.9 in September. Yesterday, Italy reported August IP as expected at -0.2% m/m vs. a revised 1.0% (was 0.8%) gain in July. Overall, recent eurozone real sector data have come in soft and should give the ECB doves cover to push back against the hawks, who want to end accommodation due to rising inflation pressures. ECB’s Makhlouf, Knot, Villeroy, Lane, Elderson, and Lagarde all speak today. The next policy meeting October 28 is likely to be contentious and no decision on QE is expected until the December meeting.

Brexit tensions are heating up. Again. U.K. Brexit Minister Frost will reportedly call for “a significant change” to the Northern Ireland Protocol in a speech today. Reports suggest he will take an even bigger step by claiming that EU authority over the matter is a “red line” for the U.K. and that a major revision is required. For the hundredth time, we must point out that there is simply no way for the U.K. to square the circle. That is, after the U.K. left the EU, there is no way to avoid a hard border somewhere between Ireland and Britain. A hard border in the Irish Sea would not be acceptable to loyalists in Northern Ireland, while one between Northern Ireland and the rest of Ireland would bring back bad memories of the Troubles.

Reports suggest the EU will release its own policy proposals tomorrow. It has said it would try to find a cooperative solution but has also threatened sanctions if the U.K. were to take unilateral action. A costly trade war is probably the last thing Europe needs right now. However, such a development would most likely hurt the smaller country the most. To put it bluntly, the U.K. needs the EU more than the EU needs the U.K. And let’s not forget that the U.K. is still pushing the EU for so-called equivalence for British financial firms.

U.K. began its monthly data dump. Labor market data came out earlier, with unemployment falling a tick to 4.5% as expected with employment rising 235k (250k expected) in the three months ending August. Jobless claims fell -51.1k in September vs. a revised -88.0k (was -58.6k) in August. All indications point to a tight labor market, with payrolls now above pre-pandemic levels and job vacancies at all-time highs. However, we suspect it will take several months to work past distortions from the end of the jobs furlough program last month. Tomorrow brings another huge slug of U.K. data but as things stand, Bank of England officials are sounding increasingly hawkish.

The short sterling strip continues to price in an aggressive BOE tightening cycle. A hike before year-end is now fully priced in, as are three more hikes to follow in 2022. Despite the heightened BOE tightening expectations, we believe the fundamental backdrop for sterling remains negative. It should underperform the euro and we have long felt that the .8450 low from August would provide a strong floor for the EUR/GBP cross ahead of a significant move higher. For cable, a break below $1.3510 is needed to set up a test of the September 29 cycle low near $1.3410.

There seems to be no end to market-negative headlines from Turkey, with the latest being the risk of military action in Syria. President Erdogan said he would eliminate the threats from Syria “either through forces that are active there, or by our own means.” This is on top of the sanctions risk we previously discussed following the potential purchase of more Russian defense missile systems. As a side note, Turkey’s August IP data came in above expectations at 13.8% y/y but was entirely ignored by markets. The lira depreciated another 0.5% against the dollar so far this week, making new all-time highs above the TRY9.0 level. CDS prices continue to creep higher, now at 446 bp.

ASIA

China’s regulatory eye has turned back to financial institutions. Reports say that officials will start investigating the connections to the private sector firms. This includes the big state-owned banks, insurers, and bad-debt managers, 25 firms in total, according to Bloomberg. The investigation will last for two months, focusing on corruption. It won’t take much for investors to interpret the move, at least in part, as the state’s effort to increase its clout over China’s private sector activities.

The Bank of Korea kept rates on hold at 0.75% as expected, but more tightening is on the way. Two MPC members dissented in favor of a hike. The downside external risks to the economy have grown, but this doesn’t seem to be the focus for the BOK. The priority now will be on controlling above target inflation and reducing financial sector risks, largely stemming from elevated borrowing in the private sector. Governor Lee stressed the bank could intervene in FX and bond markets if needed to ensure stability. Today’s hold reinforces our view that the bank will remain on a gradual tightening cycle after it started with a surprise 25 bp hike at the last meeting August 26. The BOK is likely to deliver another hike at the November 25 meeting.

COMMODITIES

More flooding in China led to a spike in coal futures to another record high. This means that energy shortages will continue for some time, probably through the winter. The floods also displaced over 120K people. Coal futures on the Zhengzhou Exchange are up nearly 20% this week to 1.5K yuan a ton.

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