Dollar’s Post-FOMC Minutes Bounce Stalls

January 06, 2022
  • Everything the market thought it knew about Fed policy this year was upended by the FOMC minutes; markets reacted as one would expect; ahead of the jobs data, we will get the last major clue; Peru is expected to hike rates 50 bp to 3.0%.
  • Germany reported firm November factory orders; December eurozone inflation readings will continue to roll out; ECB officials remain split; U.K. reported firm final services and composite PMIs; calls for U.K. tax cuts are growing; Turkey’s central bank restarted its bond-buying program to help push borrowing costs lower; the situation in Kazakhstan remains tense
  • Japan reported firm final services and composite PMIs; 10-year JGB yield rose to 0.12%, the highest since March 2021; Caixin reported firm December services and composite PMI readings; losses continue to mount for Asia equity indices as yields rise and the tech sector comes under further pressure; cryptocurrencies continue to sell off

The dollar’s post-FOMC minutes bounce is running out of steam. After trading as high as 96.287 today, DXY is now trading flat near 96.151. We still need to see a break above 96.40, which would set up a test of the December cycle high near 96.91. The euro remains heavy and has been unable still to get much traction above $1.13. GBP is also heavy after failing to break above $1.36 yesterday before the FOMC minutes. Lastly, USD/JPY is struggling to make a clean break above 116 for the third straight day. Despite today’s drop back below 116, we continue to target the December 2016 high near 118.65. Indeed, the dollar should mount a broad-based leg higher in the coming days and weeks as markets continue to reprice the Fed outlook (see below).

AMERICAS

Everything the market thought it knew about Fed policy this year was upended by the FOMC minutes. We knew the tone would be hawkish since the Fed accelerated its tapering at that December meeting. However, the minutes went above and beyond what we expected. First off, “Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.” This speaks for itself. Furthermore, the Fed is already thinking two steps ahead in discussing balance sheet runoff, as "Almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate. However, participants judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience." This means a much quicker timeline between rate hikes and balance sheet runoff than the last time and of course, this is dollar-positive. We thought this was a 2023 story but H2 of this year is in play for runoff.

Markets reacted as one would expect. WIRP now suggests nearly 80% odds of liftoff March 16 vs. 65% before the minutes, while a fourth hike this year is starting to get priced in. The nominal US 10-year yield has hit a new high near 1.73%, while the real yield jumped to -81 bp (the highest since June 2021) as the 10-year breakeven inflation rate has fallen to 2.54%. The U.S. 2-year yield is also trading at a new cycle high around 0.87% and so both US-German and US-Japan 2-year differentials are making new cycle highs of 145 bp and 94 bp, respectively. Despite these moves, we believe the markets still have some more repricing to do. Perhaps the 10-year yield should be closer to 2%? Or perhaps the expected terminal Fed Funds rate should be above 2%? Perhaps stock markets should adjust too, as equities were priced for perfection with only modest Fed tightening seen this year and next. We think that looks overly optimistic now, though we really don't agree with some macro strategists that are calling for an equity market correction. Daly and Bullard speak today and we expect them to push the same narrative as the minutes did.

Ahead of the jobs data, we will get the last major clue. ISM services will be reported, with the headline expected at 67.0 vs. 69.1 in November. Here, the employment component stood at 56.5 in November. Yesterday, ADP reported 807k private sector jobs were added last month vs. 410k expected and a revised (505k was 534k) in November. We all know by now not to get too excited about ADP numbers, but all the clues so far are pointing to a solid NFP this Friday. Consensus is currently 425k but the ADP reading will likely push the whisper number higher. Still, the jobs data has taken on less importance as the Fed has already sped up tapering with an eye to rate hikes and balance sheet runoff soon afterward. Barring a total collapse in the economy and labor market, we think the Fed remains on task to do just that. December Challenger job cuts, November trade (-$81.0 bln expected), weekly jobless claims, and factory orders (1.5% m/m expected) will also be reported.

Peru central bank is expected to hike rates 50 bp to 3.0%. A couple of analysts look for a larger 75 bp move. Inflation was 6.43% y/y in December, the highest since January 2009 and further above the 1-3% target range. The central bank just delivered the expected 50 bp hike to 2.5% at the December 9 meeting. However, with inflation still accelerating, the bank may have to pick up the pace of tightening and so we see risks of a hawkish surprise today. Bloomberg consensus sees the policy rate peaking at 4.0% by year-end, which likely understates the bank’s need to tighten.

EUROPE/MIDDLE EAST/AFRICA

Germany reported firm November factory orders. They were expected at 2.3% m/m but instead jumped 3.7% vs. a revised -5.8% ( waw -6.9%) in October. Germany reports IP (1.0% m/m expected) and trade data Friday. While the bounce in the German November data is welcome, the December PMI readings suggests rising risks of recession. The composite PMI came in at 49.9, the first time below the 50 boom/bust level since June 2020 and down sharply from the 62.4 peak in July 2021.

December eurozone inflation readings will continue to roll out. Germany reports CPI data shortly, with headline EU Harmonized inflation expected at 5.6% y/y vs. 6.0% in November. German state data out so far today suggest upside risks to the national reading, as all of them show inflation accelerating from November. The eurozone reports Friday, with headline inflation expected at 4.8% y/y vs. 4.9% in November and core expected at 2.5% y/y vs. 2.6% in November. Eurozone reported November PPI today, which came in at 23.7% y/y vs. 23.2 expected and 21.9% in November. This suggests pipeline price pressures remain strong, with upside risks to the CPI reading in early 2022.

ECB officials remain split. Kazaks sounded hawkish yesterday but that is to be expected. He said an early 2023 rate hike is possible, and that the ECB stands ready to remove stimulus if necessary. Today, Villeroy sounded dovish but that too is to be expected. He said that eurozone inflation is close to peaking, noting that December CPI data from France is showing the first signs of stabilization. Villeroy added that “While remaining very vigilant, we believe that supply difficulties and energy pressures should gradually subside over the course of the year.” We continue to believe that with Germany tipping into recession and other economies slowing sharply, ECB tapering is shaping up to be a big policy mistake. Financial conditions will tighten in the eurozone this year at the worst possible time and we are already seeing other signs of stress. Italian yields have risen over the past few weeks and low demand for its 30-year bond offer yesterday is just another sign of trouble ahead.

U.K. reported firm final services and composite PMIs. Services PMI came in at 53.6 vs. 53.2 preliminary to 52.1, which dragged the composite up to 53.6 from 53.2 preliminary. Still, the composite PMI is down two straight months and the lowest since February 2021 and so there is not much to cheer about. Much of the November data came in firmer than expected, though some of the strength in consumption was attributed to early shopping due to supply chain concerns ahead of the holidays. We may have to wait until January to get a cleaner read on the U.K. economy but we see headwinds ahead from Brexit, energy shortages, and planned fiscal and monetary tightening.

Indeed, calls for U.K. tax cuts are growing. Cabinet member Jacob Rees-Mogg told his colleagues that the 1.25% increase in the payroll tax should be shelved as the rise in inflation and energy costs is hurting family pocketbooks. That tax is set to kick in this April and is meant to help fund the National Health Service and social services. Rees-Mogg’s comments come after twenty Tory backbenchers called for Johnson and Chancellor Sunak to end the 5% VAT on energy and to remove environmental taxes on electricity. Lastly, the monthly BOE Decision Maker Panel survey showed that U.K. companies are planning to boost prices 5% over the next year, up from 4.2% in November and the highest since the survey began in 2017.

Turkey’s central bank restarted its bond-buying program to help push borrowing costs lower. Local yields have spiked recently in response to currency weakness and high inflation and so the central bank is adding bond yields to its list of targets. When all is said and done, the bank is simply trying to control too many things and will eventually lose in the end. They can't target interest rates, the exchange rate, inflation, and growth. One simply cannot square the circle unless policymakers resort to capital controls and/or price controls. Those usually end badly, to state the obvious. For now, it seems policymakers are throwing everything at the wall to see what sticks, except for the obvious solution of hiking rates. Of course, bond buying also adds liquidity to the system, which just isn't needed when inflation is running around 36%.

The situation in Kazakhstan remains tense with headlines suggesting that Russia will send troops their way. Reports claim that dozens of anti-government protesters were killed by the government’s security forces under the banner of “anti-terrorist operation.” The Kremlin will now step in with “peacekeeping forces” to support its ally, which could have wider geopolitical implications. For now, the main market impact has been an 8% increase in uranium prices, given Kazakhstan is the world’s largest supplier. It is also a major oil exporter and so crude prices are also edging higher, with Brent trading above $82 at the highest level since late November.

ASIA

Japan reported firm final services and composite PMIs. Services PMI rose a full point from the preliminary to 52.1, which dragged the composite up to 52.5 from 51.8 preliminary. Still, the composite is down from the November peak of 53.3 and this is disappointing in light of the reopened economy this past fall. Reports suggest the BOJ will downgrade its FY21 growth forecast and upgrade its FY22 forecast in its upcoming Outlook Report for the January 17-18 meeting. Otherwise, it’s steady as she goes for the BOJ. For now, the market is doing some of the heavy lifting for the bank by taking USD/JPY higher. Why rock the boat?

The 10-year JGB yield rose to 0.12%, the highest since March 2021. As the graph below shows, the rise in long-term yields is a global phenomenon, though the move in JGBs has been relatively muted compared to other major markets. Recall that the BOJ has a zero target for the 10-year yield with a tolerance band of 20 bp on each side. As such, we are not going to see any BOJ action until the yield goes to 0.20%. Unlike the RBA, we believe the BOJ will be able to maintain YCC if the market tests it.

Caixin reported firm December services and composite PMI readings. Services PMI rose a full point from November to 53.1 vs. 51.7 expected. Along with the upside surprise to its manufacturing PMI, this dragged the composite higher to 53.0 vs. 51.2 in November. Last week, official PMI readings were reported, with manufacturing at 50.3 vs. 50.1 in November, non-manufacturing at 52.7 vs. 52.3 in November, the composite steady at 52.2. Caixin’s measure tends to give more weight to exporters.

Losses continue to mount for Asia equity indices as yields rise and the tech sector comes under further pressure. The Kospi is off another -1.1% on the day, and other major indices in the region are down between 0.3-1%. We don’t see any idiosyncratic factor worth highlighting here; these markets are just high-beta plays for the broader risk appetite in the tech sector.

ALTERNATIVE INVESTMENTS

Cryptocurrencies continue to sell off, in line with moves in broader risk assets due to the rising likelihood of an accelerated Fed tightening cycle. We find that bitcoin continues to track the tech sector very well. We see this by looking at the ratio between Nasdaq and the S&P500, which has been falling sharply since mid-December. Bitcoin, and other cryptocurrencies, have followed the trend closely. Bitcoin is down about 8% this year and down 35% from its all-time high in early November.

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