Dollar Consolidates Data-Driven Gains

February 27, 2023

Win Thin

U.S. yields continue to rise; Fed tightening expectations remain elevated; regional Fed surveys for February will continue rolling out
ECB President Lagarde continues to tread the middle ground; ECB tightening expectations are drifting higher
BOJ Governor-elect Ueda had his second confirmation hearing today; reports suggest five major Japanese power companies will be forced to delay plans to hike prices until May or later

The dollar is consolidating its recent gains. DXY is trading near 105.05 after trading earlier at a new high for this move near 105.359. We look for a test of the January 6 high near 105.631. The euro traded at a new low for this move today near $1.0535 and remains on track to test the January 6 low near $1.0485. Sterling tested its 200-day moving average near $1.1930 today before recovering slightly. We look for cable to break below this level and test the January 6 low near $1.1840. USD/JPY traded at a new high for this move today near 136.55 as BOJ Governor-elect continues to signal caution about removing accommodation prematurely (see below). We look for a test of the December 20 high near 137.50, right before the BOJ shocked markets with its YCC tweak. To state the obvious, the recent U.S. data have come around to support our more hawkish view on the Fed, which in turn supports our call for a stronger dollar. Market sentiment is finally swinging back in the dollar’s favor and we remain hopeful that the data continue to encourage this shift.

AMERICAS

U.S. yields continue to rise as a result of elevated inflation data. The 2-year yield traded near 4.85% today, a new cycle high after breaking above the November 4 cycle high near 4.80%. The June 2007 high near 5.13% is up next, followed by the June 2006 high near 5.28%. The 10-year yield traded near 3.97% today, the highest since November 10 and on track to test the November 8 high near 4.24%. After that, the next target is the October 21 cycle high near 4.34%. The move higher in yields coincides with renewed inflation concerns and a much-needed repricing of Fed tightening expectations. The dollar has recovered as a result and this process still has a ways to go, in our view. The main drivers should remain in play: 1) inflation is proving to be much stickier than many expected; 2) the U.S. economy remains robust in Q1 so far, and 3) the Fed will have to go higher for longer. Markets are repricing Fed expectations and the key investment themes remain higher yields, lower equity markets, and a stronger dollar.

Fed tightening expectations remain elevated. WIRP suggests 25 bp hikes in March, May, and June are priced in that takes Fed Funds to 5.25-5.50%. Right now, odds are running around 30% of a fourth hike in July but this should rise if the data continue to run hot. Strangely enough, an easing cycle is still expected to begin in Q4, albeit at much lower odds. Eventually, it should be totally priced out into 2024 in the next stage of Fed repricing. There are plenty of Fed speakers this week and we expect them to tilt heavily hawkish. Jefferson speaks today.

Regional Fed surveys for February will continue rolling out. Dallas Fed reports its manufacturing index and is expected at -9.3 vs. -8.4 in January. Richmond Fed reports its manufacturing index Tuesday and is expected at -5 vs. -11 in January. Dallas Fed also reports its services index Tuesday. The manufacturing sector is clearly slowing, as is the housing sector. However, the services sector has remained strong enough to keep the economy humming along. January durable goods orders (-4.0% m/m expected) and pending home sales (1.0% m/m expected) will be reported Monday. The Atlanta Fed’s GDPNow model is currently tracking 2.7% SAAR growth in Q1, up from 2.5% previously. The next model update comes today after the data.

EUROPE/MIDDLE EAST/AFRICA

ECB President Lagarde continues to tread the middle ground. Over the weekend, she said “There’s every reason to believe that we’ll do another 50 bp in March. After that, we’ll see. We’re data dependent.” The hawks have pushed for a follow-up 50 bp in May but there has been pushback from the doves, who believe that pace is too steep. Madame Lagarde faces the difficult task of balancing the two factions but right now, we believe the hawks have the upper hand. We’ll know more this week as February CPI data are reported.

ECB tightening expectations are drifting higher. WIRP suggests a 50 bp hike March 16 is nearly 85% priced in. Looking further ahead, a 50 bp hike May 4 is only about 40% priced in. Another 25 bp hike June 15 is fully priced in, as is a 25 bp hike July 27 that would result in a peak policy rate near 3.75%, up from 3.5% at the start of last week. There are rising odds of one final 25 bp hike to 4.0% in Q4 and beyond but these expectations are likely to drift lower if continued disinflation gives the doves the upper hand again. For now, however, it appears that the hawks remain in the driver’s seat. De Cos and Lane speak later today.

ASIA

BOJ Governor-elect Ueda had his second confirmation hearing today. He continued to signal continuity by saying the benefits of continued stimulus outweighs its side effects. Ueda added that “I think it’s appropriate for monetary easing to be continued. In order for policy to be revised, I think there needs to be a major improvement in the price trend.” Still, he added that “we need to carefully watch to make sure there’s no risk that inflation will overshoot its goal too much.” So far, Ueda has said all the right things but perhaps his most prescient comment was that “Whoever takes the job, it’s a considerably difficult situation.”

Expected BOJ liftoff is not imminent. Next BOJ policy meeting March 9-10 will be the last one under current Governor Kuroda and while no change is expected, we simply cannot rule out one last surprise. WIRP suggests over 20% odds of liftoff April 28, rising to nearly 50% June 16 and then over 90% for July 28. That said, the actual tightening path is seen as very mild as the market is pricing in 20 bp of tightening over the next 12 months followed by only 30 bp more over the subsequent 24 months. That is why we expect the knee-jerk drop in USD/JPY after liftoff to be fairly limited. Nakagawa speaks Wednesday and Takata speaks Thursday.

Press reports suggest five major Japanese power companies will be forced to delay plans to hike prices until May or later. The government is reportedly planning to take more time to go over their requests to increase prices. As it is, planned power subsidies went into effect this month and this is the reason why Tokyo CPI is expected to fall significantly when it’s reported Friday.

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