Dollar Gets Some Traction Ahead of FOMC Minutes

May 25, 2022

U.S. yields have fallen sharply from the early May peaks; FOMC minutes will be released; flash May PMI and Richmond Fed readings were softer than expected; Brazil mid-May IPCA inflation came in higher than expected at 12.20% y/y; Deputy Governor Heath said Banxico may need to hike another 2-3 percentage points 

The U.S. has likely to pushed Russia into default; the ECB sounded some warnings in its twice-yearly Financial Stability Review; more ECB officials are lining up behind President Lagarde; soft June German GfK consumer confidence was reported

Japan’s Cabinet Office maintained its monthly economic assessment for May; RBNZ hiked rates 50 bp to 2.0%, as expected; the expected rate path macro forecasts were tweaked; incoming Australian Treasurer Chalmers is already walking back some of his pre-election spending pledges

The dollar is finally getting some traction.  DXY is trading near 102.28 after two straight down days that took it as low as 101.646, the lowest since April 26.  Key level to watch is 101.80 as a break below would set up a test of the April 21 low near 99.818.  The euro is trading back near $1.0665 after yesterday’s move to $1.0750 ran out of steam.  USD/JPY remains heavy near 127 as risk sentiment remains vulnerable.  Sterling is trading back near $1.25 after being unable to break above $1.26 this week.  We still view this recent move lower as a correction within the longer-term dollar rally but we continue to be surprised at how far the dollar has fallen from the early May peak. We continue to believe that pessimism regarding the U.S. is overdone, with markets overlooking the deep-seated problems in the eurozone, U.K. and Japan.

AMERICAS

U.S. yields have fallen sharply from the early May peaks.  The 10-year yield is currently trading near 2.75% vs. the May 9 peak near 3.20%,while the 2-year yield is trading near 2.52% vs. the May 4 peak near 2.85%.  Part of this drop has been some persistent risk-off impulses, but we feel a large part of it reflects concerns about the economic outlook due to some soft U.S. survey data.  This has also led Fed tightening expectations lower, with the swaps market now pricing in a terminal Fed Funds rate of 3.0% vs. 3.75% in early May.   

However, we note that jobs and retail sales data have remained firm.  Consensus sees 350k jobs added this month, down from 428k in April but still solid.  Also, the unemployment rate is seen falling a tick to a new cycle low of 3.5%.  Taking a broader view, our two favorite indicators – the 3-month to 10- year yield curve and the Chicago Fed National Activity – suggest recession fears are overblown.  While the slope of the curve has fallen to 178 bp from the 231 bp peak in early May, it remains far from inversion.  Likewise, the Chicago Fed NAI also remains far from recessionary readings.  We believe that U.S. yields will resume rising as risk off impulses ebb and that should help the dollar in the coming days.  

FOMC minutes will be released.  At the May 3-4 meeting, the Fed hiked rates the expected 50 bp to 1.0% and laid out plans for aggressive Quantitative Tightening to begin in June.  As a result, we expect the minutes to come in quite hawkish.  Since then, Fed officials have been uniformly hawkish, with the exception of Bostic and his talk of a September pause.  We do not think he represents consensus and we do not think any Fed officials should be hinting at any pre-ordained plans.  After expected 50 bp hikes in June and July, the Fed is literally taking it a meeting at time to see how the data unfold.  Our base case remains for another 50 bp hike in September that takes the Fed Funds ceiling up to 2.5%, which many consider close to neutral.  However, it’s worth noting that odds of a 50 bp move in September have fallen to less than 50% now from fully priced in at the start of May.  Brainard speaks today.  

S&P Global flash May PMI readings were softer than expected.  Manufacturing PMI came in at 57.5 vs. 57.7 expected and 59.2 in April, while services PMI came in at 53.5 vs. 55.2 expected and 55.6 in April.  The weak services helped drag the composite down to 53.8 vs. 55.7 expected and 56.0 in April. This puts the U.S. above the U.K. (51.8 composite), Japan (51.4), and Australia (52.5) but below the eurozone (54.9).  This may help the euro remain bid but we think this is one of those rare and temporary situations when the eurozone economy outperforms the U.S.  Durable goods orders will be reported today and are expected at 0.6% m/m vs. 1.1% in March.  

Regional Fed manufacturing surveys continue to come in weak.  Richmond Fed came in at -9 vs. 10 expected and 14 in April.  Kansas City reports Thursday and is expected at 18 vs. 25 in April.  Last week, Empire came in at -11.6 vs. 24.6 in April and Philly Fed came in at 2.6 vs. 17.6 in April. The S&P flash May manufacturing PMI reading of 57.5 is still quite high and so the regional Fed surveys seem to be overstating the weakness in manufacturing.  ISM manufacturing PMI will be reported next Wednesday and is expected to remain steady at 55.4. 

Brazil mid-May IPCA inflation came in higher than expected at 12.20% y/y, a new high for the cycle and further above the 2-5% target range. Next COPOM meeting is June 15 and the CDI market is pricing in a 50 bp hike to 13.25%.  Looking ahead, the swaps market is pricing in 100 bp of tightening over the next 6 months that would see the policy rate peak near 13.75%.  Brazil President Bolsonaro decision to fire a third CEO at Petrobras shows just how worried he is about inflation.  In particular, fuel prices have surged as state-owned Petrobras has boosted diesel costs by about 35% since March. The most recent Ipespe poll carried out May 16-18 suggests Bolsonaro’s support has topped out around 32% in, 14 percentage points behind front-runner Lula. The same poll showed more Brazilians blame soaring fuel prices on Bolsonaro than on Russia’s invasion of Ukraine.  

Deputy Governor Heath said Banxico may need to hike another 2-3 percentage points.  He added that rates need to go past the “neutral zone” to restrictive, at which point both economic growth and inflation will slow.  Heath is following up on hawkish comments earlier this week, when he hinted that a 75 bp hike in June was possible.  Mid-May CPI slowed slightly to 7.58% y/y and so we favor a 50 bp hike at the next meeting June 23.  The swaps market agrees with Heath as it is currently pricing in another 225 bp of tightening  that would see the policy rate peak near 9.25%. 

EUROPE/MIDDLE EAST/AFRICA

The U.S. has likely to pushed Russia into default.  The Treasury Department said it does not plan to extend  the exemption that allowed Russia to keep paying its foreign debtholders through U.S. banks.  Since the first rounds of sanctions, Treasury had allowed U.S.  banks to continue processing dollar-denominated bond payments from Russia but that will now expire at midnight tonight.  We cannot recall any other instances where a debtor has the ability and willingness to services its debt but is prevented from doing so.  This move has been well-telegraphed and so we expect bondholders to have adjusted their holdings accordingly.  Indeed, experts believe those that are still holding Russian external debt are distressed debt investors and those willing to litigate for the payments.  Of course, there is still a lot of foreign investment still tied up in ruble-denominated debt as capital controls are preventing their sale and repatriation of the proceeds.  

The ECB sounded some warnings in its twice-yearly Financial Stability Review.  Specifically, it warned that some eurozone firms are struggling from the combination of high commodity prices and slower economic growth caused by the Ukraine crisis.  The report noted that “These vulnerabilities are compounded by the prospect of tighter financing conditions that would adversely affect the debt servicing capacity of lower-rated firms in particular.”  The bank also warned that the eurozone financial system also needs to prepare for another possible correction to asset markets as “Such corrections could be triggered by a further escalation of the war, emerging market stresses or by more persistent inflation than currently foreseen, which might prompt faster monetary policy normalization by major central banks.”  Guindos noted that “The terrible war in Ukraine has brought immense human suffering.  It has also increased financial stability risks through its impact on virtually all aspects of economic activity and financing conditions.”

More ECB officials are lining up behind President Lagarde.  ECB Chief Economist Lane said he agreed with Lagarde’s forward guidance and stressed that the rate path she outlined this week is “clear” and represents “robust policy.”  We continue to believe Lagarde and Lane represent ECB consensus, while Holzmann and Nagel are still outliers in the hawkish wing.  Noted hawk Knot also endorsed Lagarde’s view today, stressing “I’m fully on board, I fully support everything that is in the blog.  I think it nicely charts the policy course.”  We believe market pricing for 25 bp hikes at each meeting in H2 is correct, at least as things stand now.  Looking further ahead, the swaps market is pricing in 150 bp of tightening over the next 12 months followed by another 25 bp of tightening the following 12 months that would see the deposit rate peak near 1.25% vs. 1.75% at the start of the month.   Rehn, Panetta, Holzmann, Lagarde, de Cos, and Lane all speak today. 

Soft June German GfK consumer confidence was reported.  It came in at -26.0 vs. -25.5 expected and a revised -26.6 (was -26.5) in May.  This comes after firmer than expected IFO survey Monday and flash PMI readings Tuesday, suggesting the German economy may be bottoming.  Elsewhere, Q1 GDP details show private consumption contracted -0.1% q/q and government spending only rose 0.1% q/q.  It was strong capital investment (2.7% q/q) that boosted GDP enough to eke out a modest growth of 0.2% q/q, unchanged from the preliminary reading.  This will be difficult for German firms to maintain in Q2. 

ASIA

Japan’s Cabinet Office maintained its monthly economic assessment for May after upgrading it in April.  It said that the economy is showing signs of picking up and boosted its outlook for housing.  It added that the labor market is showing signs of improvement but acknowledged high energy costs are a growing problem.  Elsewhere, reports suggest the government will urge the Bank of Japan to achieve its 2% inflation goal in a “sustainable and stable fashion.”  This subtle tweak in the language reflects growing concern that high inflation will start to erode Kishida’s popularity.  However, as things stand, Governor Kuroda is showing no signs of a hawkish pivot and is likely to maintain current policy settings through the end of his term next spring.  It will be up to Kishida to choose a successor for Kuroda that is prepared to remove stimulus.   

Reserve Bank of New Zealand hiked rates 50 bp to 2.0%, as expected.  However, the bank signaled a much steeper rate path ahead as it now sees the policy rate peaking near 4.0% in Q3 23 vs. a 3.35% peak in 2024 seen in the February projections.  The bank said “It remains appropriate to continue to tighten monetary conditions at pace to maintain price stability and support maximum sustainable employment.  The Committee is resolute in its commitment to ensure consumer price inflation returns to within the 1-3% target.”  The language implies that another 50 bp hike to 2.5% is likely at the next meeting July 13.  Looking ahead, the swaps market now sees 250 bp of further tightening over the next 12 months that would see the policy rate peak near 4.5% vs. 3.75% at the start of this week.  

The macro forecasts were tweaked.  Most of the adjustments centered on the 2022 and 2023 inflation forecasts, which were marked significantly higher.  However, growth forecasts for 2024 and 2025 were cut to reflect the impact of the steeper expected rate path. 

Incoming Australian Treasurer Chalmers is already walking back some of his pre-election spending pledges.  He stressed that the incoming Labor government needs to be “responsible and measured” on fiscal spending.  Chalmers noted that “There’s a lot of pressure on the budget.  There’s no room in the budget, with AUD1 trln in debt, to do everything that we would like to do, or to do even all of the good ideas. So we need to weigh up our priorities and try to sequence things.”  He added that it will be hard to extend fuel tax relief announced in March by the previous government beyond September as it would cost “billions of dollars.”  This is the prudent approach to take, as aggressive fiscal stimulus at this stage would add significantly to existing price pressures.

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