Dollar Remains Soft Ahead of ECB Decision

July 27, 2023

Win Thin

The two-day FOMC meeting ended with an expected 25 bp hike, as expected; Powell stayed on message during the press conference.; advance Q2 GDP data will be reported; housing sector data will remain in focus; BOC released the summary of its deliberations
The two-day ECB meeting ends shortly with an expected 25 bp hike; ahead of the decision, there were some data releases from eurozone countries; U.K. CBI released the results of its July distributive trades survey; Turkey central bank released its quarterly inflation report
The two-day BOJ meeting started today and ends tomorrow with an expected hold; while the BOJ always has the capacity to surprise markets, we do not think Governor Ueda will risk losing his credibility now

The dollar is soft ahead of the ECB decision. DXY is trading lower for the second straight day near 100.574 after six straight up days. The euro is trading higher near $1.1145 ahead of an expected 25 bp hike (see below) while sterling is trading higher near $1.2965. USD/JPY traded as low 139.40 today before recovering to trade back above 140 as markets get defensive about a surprise from the BOJ tomorrow (see below). That said, we believe a hold from the BOJ will trigger a move higher in this pair. We had been frustrated with recent dollar weakness but the relative fundamental story seems to be shifting back in favor of the greenback. The FOMC, ECB, and BOJ decisions this week are widely expected to underscore the divergence theme and so further dollar gains seem likely.

AMERICAS

The two-day FOMC meeting ended with an expected 25 bp hike, as expected. The decision was unanimous. The Fed noted that “Recent indicators suggest that economic activity has been expanding at a moderate pace. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated.” Similar to its previous statements, the Fed said that “In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” There won’t be updated macro forecasts and Dot Plots until the September 19-20 meeting. WIRP suggests odds of a hike then around 20% and top out near 40% November 1. It’s worth noting that the first cut is largely priced in for next March but this is of course open to repricing and dependent on the data.

Powell stayed on message during the press conference. He stressed that the Fed hasn’t made a decision to hike at every other meeting, adding that it would hike in September if the data warranted. Powell said the slowdown in June CPI was welcome but stressed it was only one month. He said the Fed needs to stay “on task” and that the Fed needs to hold rates “for some time.” He noted that core inflation is a better signal of where headline inflation is going and the Fed wants core to come down as it’s still elevated. He then made two interesting points: 1) the Fed staff is no longer forecasting a recession and 2) the Fed could cut rates even while the balance sheet is shrinking. Lastly, Powell said there is a range of views on the FOMC. Yes, the decision was unanimous but there are still clearly differences just as there were at the May meeting. Back then, the doves prevailed with the skip. Now, the hawks prevailed with a 25 bp hike and no commitment to skip.

Powell and company sent the right hawkish message but the market won’t believe them until the data back them up. We will get a lot of data to digest today and tomorrow that will underscore that 1) the U.S. economy continues to grow at or above trend and 2) continues to outperform Europe and the U.K. even as 3) inflation remains stubbornly higher across most major economies. The economic outlooks continue to diverge, with the eurozone and U.K. slipping into recession even as the U.S. avoids one for now. This divergence theme is likely to remain in play and will eventually show up in monetary policies as well.

Advance Q2 GDP data will be reported. Consensus stands at 1.8% SAAR vs. 2.0% in Q1. Of note, the Atlanta Fed’s GDPNow model final update has Q2 growth at 2.4% SAAR, unchanged from the previous reading. After Q2 GDP is reported today, the Atlanta Fed’s initial estimate for Q3 growth will then be released tomorrow. Bloomberg consensus for Q3 currently stands near 0.5% SAAR and will likely move higher if momentum in the economy is sustained, as we expect.

Housing sector data will remain in focus. Pending home sales are expected at -0.5% m/m vs. -2.7% in May. Yesterday, June new homes sales came in at -2.5% m/m vs. -5.0% expected and a revised 6.6% (was 12.2%) in May.

Other minor data will round out the U.S. picture. June durable goods orders (1.3% m/m expected), advance goods trade (-$92.0 bln expected), wholesale and retail inventories, and weekly jobless claims will all be reported. Initial claims are expected at 235k vs. 228k last week, while continuing claims are expected at 1.75 mln vs. 1.754 mln last week. Of note, the continuing claims data are reported with a one-week lag and so this week’s reading is for the BLS survey week containing the 12th of the month. Current Bloomberg consensus for July NFP stands at 185k vs. 209k in June. Kansas City Fed manufacturing index will also be reported and is expected at -10 vs. -12 in June. Kansas City services index will be reported tomorrow.

Bank of Canada released the summary of its deliberations. At the July 12 meeting, it hiked rates 25 bp to 5.0% but debated a hold as well. The summary showed that the rate path remains finely balanced and that “Given the uncertainties around the forecast and the size and timing of the impact of higher interest rates on demand, they would approach future decisions one at a time based on the available evidence.” Looking forward, policymakers reiterated that they would monitor excess demand, inflation expectations, wage growth, and business pricing behavior in order to measure inflation risks. WIRP suggests 35% odds of a hike at the next meeting September 6, rising to nearly 70% October 25 and 85% December 6. As the summary suggests, it will all come down to the data.

EUROPE/MIDDLE EAST/AFRICA

The two-day ECB meeting ends with an expected 25 bp hike. The big question is how the bank frames the debate going forward. At the last meeting June 15, the bank hiked 25 bp and President Lagarde said the bank was very likely to continue hiking rates in July, adding that there is still ground to cover and that the ECB is not yet at its destination. We think this language will be softened after leading hawks Knot and Nagel signaled last week that they were not committed to a September hike. The usual hawk vs. dove dynamics have likely shifted as the data have turned down. Bottom line: we expect the ECB to take the middle ground and set forth a conditionally hawkish message that is similar to the data-dependent one from the Fed yesterday.

The end of the ECB tightening cycle is within sight. WIRP suggest odds of a 25 bp hike stand near 50% September 14, rise to 70% October 26, and top out near 80% December 14. Updated macro forecasts will come at the September meeting. Of note, Lagarde added in June that the ECB is not “thinking about” pausing. However, the fact that she mentioned it suggests that the ECB is actually “thinking about thinking about” pausing. As such, we see risks that Lagarde inserts the notion of a pause or end in tightening during her press conference. Even some sort of validation of current market pricing would be a confirmation of this. Believe it or not, it’s quite possible that the ECB stops hiking before the Fed does and that would be negative for the euro.

Ahead of the decision, there were some data releases from eurozone countries. Germany reported August GfK consumer confidence. Headline came in at -24.4 vs. -24.8 expected and a revised -25.2 (was -25.4) in June. Elsewhere, Spain reported June retail sales at 6.4% y/y vs. a revised 6.1% (was 6.0%) in May. Germany has been the weak link in the eurozone but France and Italy are quickly catching up. Despite the firm sales data, Spain also likely to tip into recession eventually.

The U.K. CBI released the results of its July distributive trades survey. Retailing reported sales came in at -25 vs. -9 expected and actual in June. Total reported sales came in at -17 vs. -12 in June. Retail sales have held up surprisingly well given how much household budgets are getting squeezed. July retail sales won’t be reported until August 18 but the weak CBI survey suggest some downside risks.

BOE tightening expectations remain subdued. WIRP suggests odds of a 50 bp hike August 3 have fallen to 35% after being largely priced in earlier this month. Looking ahead, 25 bp hikes September 21 and November 2 are priced in while the odds of one last 25 bp hike top out near 65% in February. This lower expected rate path would see the bank rate peak between 5.75-6.0% vs. 6.5% earlier this month. This is a huge downward adjustment that has taken a toll on sterling.

Turkey central bank released its quarterly inflation report. Inflation forecasts were raised significantly from the May report. Inflation is forecast at 58% for end-2023 vs. 22.3% previously, 33% for end-2024 vs. 8.8% previously, and 15% by end-2025 vs. 5.0% previously. The 5% inflation target will be maintained. Governor Erkan said the central bank is laying the groundwork for the start of disinflation next year, with CPI expected to peak around 60% in Q2 before improving. She made other market-friendly statements but when all is said and done, this report simply does not justify the bank’s dovish surprise last week. The swaps market is pricing in a peak policy rate near 29.25% over the next twelve months and that is simply not enough to stabilize the lira and meet even these updated inflation forecasts.

ASIA

The two-day Bank of Japan meeting started today and ends tomorrow with an expected hold. Recent reports suggest, contrary to market speculation, that the bank will not tweak its Yield Curve Control yet. We concur and see an October tweak as more likely. Updated macro forecasts will be released and other reports suggest upward revisions to the FY23 core inflation forecast followed by a possible cut in the FY24 forecast. This would certainly seem to justify steady policy as we truly believe that policymakers remained very concerned about removing accommodation too soon.

While the BOJ always has the capacity to surprise markets, we do not think Governor Ueda will risk losing his credibility now. He has been quite clear in his comments that the bank is not ready to pivot. We are early in his tenure and we believe that Ueda wants to build trust and a rapport with the markets as the BOJ navigates what really are uncharted waters. After decades of ultra-loose policy, how can the BOJ successfully exit? Ueda and his colleagues simply do not know how markets and the real economy will react to an eventual pivot and so we think they will try to avoid surprising the markets.

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