Dollar Remains Under Pressure

July 11, 2023

Win Thin

Fed officials remain hawkish; the dollar remains vulnerable to selling pressure this week that carried over from last week; Brazil reports June IPCA inflation
Turkey agreed to support Sweden’s NATO bid ahead of this week’s summit; German reported a soft July ZEW survey; U.K. reported mixed labor market data
Japan reported weak June machine tool orders; recent yen strength is puzzling within the context of weaker Japan data. reports suggest China will provide additional relief to the property sector

The dollar remains under pressure. DXY is trading lower for the fourth straight day anear 101.71. Yet the odds of a second Fed hike are still around 35% and so we’d look to fade this current bout of dollar weakness. The euro is trading flat near $1.10 while sterling is trading higher near $1.2920. USD/JPY remains heavy after being unable to break above 145 and is testing the 140 area. With the jobs report in the rear view mirror, markets need to start focusing on this week’s CPI and PPI data. The fundamental story continues to favor the dollar (see below) and markets are still seeing significant risks of a second Fed hike this year. The inflation data will be key to further repricing of Fed policy and we view current dollar softness as a temporary setback.

AMERICAS

Fed officials remain hawkish. Vice Chair Barr said “We’ve made a lot of progress in monetary policy, the work that we need to do, over the last year, I would say we’re close, but we still have a bit of work to do.” Daly said “We’re likely to need a couple more rate hikes over the course of this year to really bring inflation back into a path that’s along a sustainable 2% path.” Mester said “In order to ensure that inflation is on a sustainable and timely path back to 2%, my view is that the funds rate will need to move up somewhat further from its current level and then hold there for a while as we accumulate more information on how the economy is evolving.” We believe a 25 bp hike this month is a done deal. WIRP suggests a 25 bp hike this month is largely priced in, while the odds of a second 25 bp hike this year are still around 35%. There are no Fed speaks nor major U.S. data today.

Without any major US data until CPI tomorrow, it seems the dollar remains vulnerable to selling pressure this week that carried over from last week. Yet the fundamental story favors the U.S. Yes, there are some pockets of softness but the economy continues grow near trend at a time when the Fed is seeking below trend growth. The Atlanta Fed’s GDPNow model is currently tracking 2.3% SAAR in Q2 vs. 2.1% previously. The next model update comes next Tuesday. Contrast this to the eurozone, where PMI readings suggest France and Italy are already in recession and Germany not far behind. Or the U.K., where aggressive BOE tightening is likely to lead to a deep recession. Or Japan, where domestic activity is starting to slow.

Brazil reports June IPCA inflation. Headline is expected at 3.14% y/y vs. 3.94% in May. if so, it would be the lowest since September 2020 and well within the 1.75-4.75% target range for this year. With inflation falling, COPOM is widely expected to start the easing cycle at the next meeting August 2 with a rate cut. The swaps market is pricing in 75 bp of easing over the next three months followed by another 125 bp of easing over the subsequent three months. May retail sales will be reported Friday and expected at 1.3% y/y vs. 0.5% in April.

EUROPE/MIDDLE EAST/AFRICA

Turkey agreed to support Sweden’s NATO bid ahead of this week’s summit. This is a major breakthrough as it continues to trend of Western European integration after Russia’s invasion of Ukraine, though Hungary still needs to approve Sweden’s entry. NATO chief Jens Stoltenberg said Turkey would ask its parliament to approve Sweden’s membership “as soon as possible.” After Erdogan’s demand that Turkey be allowed to join the EU as part of the deal was rebuffed, reports suggest a deal was struck after Turkey was given assurances that the EU process would be sped up and that some defense-related sanctions would be lifted. Make no mistake, this is a very big deal for Turkey. After years of deteriorating relations with the West, it appears that Turkey is finally realizing that closer relations with Russia was not a good look. Perhaps this is yet another baby step towards Turkey becoming investable once again. Stay tuned.

German reported a soft July ZEW survey. Expectations came in at -14.7 vs. -10.6 expected and -8.5 in June, while current situation came in at -59.5 vs. -62.0 expected and -56.5 in June. After the spring bounce, this report continues the recent deterioration in German sentiment even as the economy slips into recession. Elsewhere, Italy reported May IP at 1.6% m/m vs. 0.6% expected and a revised -2.0% (was -1.9%) in April. Eurozone reports May IP Thursday and is expected at 0.3% m/m vs. 1.0% in April.

The U.K. reported mixed labor market data. The unemployment rate rose two ticks to 4.0% when it was expected to remain steady at 3.8% in the three months through May. Unemployment was the highest since January 2022 and should rise further as the economy slows under the weight of BOE tightening. And yet wage growth picked up as average weekly earnings came in at 6.9% y/y vs. 6.8% expected and a revised 6.7% (was 6.5%) through April. Wage growth is at a new high for this cycle and the most since August 2021 and the combination of rising wages and rising unemployment is obviously not good. The Bank of England will be concerned about a wage-price spiral, though it’s clear that real wages have fallen as inflation has been outpacing nominal wage growth since late 2021.

BOE tightening expectations remain elevated. WIRP suggests another 50 bp hike is largely priced August 3, followed by another 50 bp hike September 21. After that, 25 bp hikes are priced in for Q4 and Q1 that would see the bank rate peak near 6.5% vs. 6.25% at the start of last week. This would represent the most aggressive tightening cycle in the majors so far in terms of absolute magnitude and yet the benefits to sterling of a higher BOE rate path are starting to wane. That’s because a recession is now back on the table after some earlier optimism that one might be avoided. Updated macro forecasts will come at the August meeting and will have to acknowledge the worsening backdrop.

ASIA

Japan reported weak June machine tool orders. Orders came in at -21.7% y/y vs. -22.1% in May. Continued weakness in orders support our view that Japan has yet to see any significant impact from China reopening. Surprisingly, the domestic orders underperformed at -29.9% y/y vs. -16.7% y/y for foreign orders. No wonder policymakers are concerned about withdrawing accommodation too soon. May core machine orders will be reported tomorrow and are expected at 0.1% y/y vs. -5.9% in April. June PPI will also be reported tomorrow and is expected at 4.4% y/y vs. 5.1% in May. With the economy softening and price pressures easing, market expectations for Bank of Japan liftoff have been pushed into 2024.

Recent yen strength is puzzling within the context of weaker Japan data. With the BOJ on hold and the Fed still hiking, the monetary policy divergences will only widen. For now, USD/JPY remains in the 140-145 range that has held from mid-June until now after trading 130-140 from February through mid-June. We are clearly testing the bottom of that range but it should hold given the interest rate differentials. Eventually, the pair should move into a new trading range of 145-150.

Reports suggest China will provide additional relief to the property sector. Financial regulators had already been applying pressure on banks to ease loan terms for property companies with the aim of ensuring the delivery of homes that are under construction. Now, reports suggest policymakers are mulling more support measures, such as reducing down payments in some major cities, lower commissions on transactions, and relaxing restrictions on residential purchases. Reports also suggest potential measures to boost business confidence but to us, this fall eels like applying a band-aid to a gaping wound. The fact of the matter is that the property sector is so overextended that it cannot be counted on to drive domestic growth and these measures won’t address this core problem.

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