Dollar Steadies as Markets Await Fresh Drivers

June 08, 2021
  • U.S. fiscal policy remains a big unknown; today is a light day in North America; Chile is expected to keep rates steady at 0.50%; Peru’s electoral board has not yet announced an official winner for the presidential race; BRL continues to test the R$5.00 level even as fiscal headlines weigh on fixed income markets
  • U.K.-EU tensions are high and rising; ECB asset purchases for the week ending June 4 were reported; Germany reported soft April IP and June ZEW business survey; Russia inflation came in at the high end of expectations, confirming the view that the central bank will continue tightening
  • Japan reported April real cash earnings final Q1 GDP, and April current account data; Japan investors have resumed buying foreign sovereign bonds again; concerns about China’s financial stability remain high

Markets are very quiet markets ahead of the key ECB meeting and U.S. CPI data Thursday. Measures of implied volatility continue to fall. The VIX and the G7 FX implied vol measures are near cycle lows of 16.4 and 6.1, respectively. The MOVE index for U.S. Treasury implied vol has been on a downtrend over the last few months, but only broke below its 1-year average this week, now at sub-50.

On the EM side, the broad EM currency index has been closely tracking the DXY until recently. Over the last few sessions, some of the high beta EM currencies such as BRL, COP, and ZAR have posted significant gains, helping the broader index outperform. We think this is at least in part related to the aforementioned decline in volatility across markets, making higher carry plays more tempting on a volatility adjusted basis.

The dollar is getting some modest traction as markets await fresh drivers. DXY is up modestly and trading just above 90. The euro is trading heavy and remains unable to reclaim the $1.22 level, while sterling is trading just above $1.41 and remains unable to reclaim the $1.42 level. USD/JPY is trading around 109.50 and remains a bit heavy after being unable to sustain the break above 110 Friday. While we believe the fundamental story favors the dollar, there is a lot of ground recover in the coming days. Until we see a bigger move higher U.S. rates (both real and nominal), the greenback is likely to remain vulnerable to further bouts of selling. The 10-year yield is trading back at last week’s low near 1.55%, while the breakeven inflation rate has edged lower to around 2.40%, putting the real rate at around -0.85%. This is still below the -0.79% posted on Friday, the highest since late April.

AMERICAS

U.S. fiscal policy remains a big unknown. Reports suggest the two sides are at loggerheads over the planned size of the infrastructure bill. Lead Republican Senator Capito said she won’t be bringing a higher offer to the table anytime soon. Now, Democrats are left strategizing whether to use the budget reconciliation process that requires only a simple majority to pass. Yet West Virginia’s Democratic Senator Manchin has resisted this in favor of a bipartisan deal. While there is no hard deadline, reports suggest the path to a deal is narrowing ahead of the planned August recess for Congress. After that recess, Congress’ time and attention will most likely be taken up with regular spending bills that must pass by September 30 in order to avoid a government shutdown.
Today is a light day in North America. U.S. trade data (-$68.7 bln expected) and JOLTS job openings (8.2 mln expected) will be reported. There are no Fed speakers all week due to the media embargo. Canada also reports April trade data (-CAD700 mln expected).

Chile central bank is expected to keep rates steady at 0.50%. However, it has already started to hint at normalizing monetary policy in the coming months. Minutes from the May 13 meeting show the bank sees a “significantly improved” economic outlook compared to March due to fiscal stimulus and reduced risks. However, “The Board agreed that the moment the normalization process would begin remained highly uncertain.” Bloomberg consensus sees 25-50 bp of tightening in H2 that would take the policy rate to 1.0% by year-end, followed by 25 bp per quarter next year that takes the policy rate to 1.75% by Q3 22. Ahead of the decision, May CPI will be reported, with headline inflation expected to accelerate to 3.7% y/y from 3.3% in April. If so, it would be the highest since March 2020 and nearing the top of the 2-4% target range.

Peru’s electoral board has not yet announced an official winner for the presidential race. Leftist Castillo is the favorite by a narrow margin, raising the risk of protests. With 96.5% of votes counted, Pedro Castillo has 50.3% of votes against 49.7% for Keiko Fujimori. Fujimori has already alleged voter fraud. She yet to provide evidence and international observers have not voiced any concerns, but the tight race means that her supporters may take their frustration to streets. The sol tumbled 2% against the dollar yesterday and we don’t see any reason to be optimistic in the near-term.

The Brazilian real continues to test the R$5.00 level even as fiscal headlines weigh on fixed income markets. The latest development on the spending front came from lower house president Arthur Lira arguing against postponing pandemic-related outlays. This led to a roughly 10 bp widening in the back end of the swaps curve, reversing the recent flattening trend. Still, an improved growth outlook along with prospects of higher carry has propelled the real well into the strongest level for the year, gaining 13% since early March and now testing the December low.

EUROPE/MIDDLE EAST/AFRICA

U.K.-EU tensions are high and rising. We saw some verbal back-and-forth yesterday, but the talk has turned more serious as European Commission Vice President Sefcovic warned that it will take stronger actions if the U.K. fails to implement the parts of the Brexit deal that relate to Northern Ireland, adding that “Unfortunately, we see numerous and fundamental gaps in the U.K.’s implementation.” The U.K. is reportedly considering a unilateral extension of the grace period set to expire June 30 that allows sausages and other chilled meat products to continue freely moving between England and Northern Ireland without customs checks. EU suspended planned legal action over U.K. unilateral action regarding Northern Ireland earlier this year, but it appears patience is running out in Brussels. These latest tensions come ahead of a key meeting tomorrow where the two sides will seek ways to prevent further tensions over Northern Ireland.

ECB asset purchases for the week ending June 4 were reported. Net purchases were EUR20.6 bln vs. EUR20.0 bln for the week ending May 28 and EUR21.7 bln for the week ending May 21. Gross purchases will be reported today, which were EUR25.0 bln for the week ending May 28 vs. EUR23.7 bln for the week ending May 21. Both net and gross purchases have picked up noticeably over the last few weeks, and yet eurozone yields are still higher. We maintain our long-standing call that the ECB’s accelerated asset purchases will be extended through Q3 at this week’s meeting.

Germany reported soft April IP and June ZEW business survey. IP was expected to rise 0.4% m/m but instead fell -1.0%. The March gain was revised down to 2.2% from 2.5% previously. Today’s IP data mirror yesterday’s disappointing factory orders data, and belies the strong manufacturing PMI readings out of Germany in recent months. ZEW expectations fell to 79.8 vs. 86.0 expected and 84.4 in May, while ZEW current situation rose to -9.1 vs. -28.0 expected and -40.1 in May. Elsewhere, Italy reported April retail sales, which fell -0.4% m/m vs. an expected 0.2% gain and a revised flat reading (was -0.1%) in March. With hard eurozone data coming in on the weak side so far in Q2, it’s a no-brainer for the ECB to maintain its dovish stance.

Russia inflation came in at the high end of expectations, confirming the view that the central bank will continue tightening. CPI rose 6.0% y/y in May vs. 5.8% expected, the highest level since mid-2016 and further above the 4% target. Much of the increase came from higher food prices, but other categories such as consumer goods and services also accelerated. We have no doubt that the CBR will hike again this Friday, but we don’t think the data warrants a more aggressive move beyond the 50 bp already priced it, especially with the ruble on a two month strengthening trend. However, the higher inflation numbers, along with other solid data, suggests that the cycle will likely go on for a few more meetings.

ASIA

Japan reported April real cash earnings and final Q1 GDP data. Earnings rose 2.1% y/y vs. 1.4% expected and a revised 0.8% (was 0.5%) in March. GDP contracted a revised -1.0% q/q vs. -1.2% expected and -1.3% preliminary. It was nothing to celebrate, however, as private consumption was revised down a tick to -1.5% q/q, while inventories contributed 0.4% to growth. This combination does not bode well for growth going forward. With the economy potentially contracting in Q2 as well, we fully expect another fiscal package over the summer to help boost growth and Prime Minister Suga’s popularity.

Japan also reported April current account data. The adjusted surplus came in close to consensus at JPY1.55 trln is expected vs. JPY1.7 trln in March. However, the investment flows were of most interest as April is the first clean read in several months as activity in February and March came ahead of the end of the fiscal year and amidst a deepening global sell-off in bonds that culminated in late March. It turns that Japanese investors came back with a vengeance in April buying JPY1.7 trln of U.S. sovereign bonds, the most since November. Japanese investors also bought the most Canadian and Australian sovereign debt since October at JPY231.5 bln and JPY341.8 bln, respectively. It appears that some sort of rotation trade may have been in effect, as Japanese investors sold JPY1.6 trln of U.S. equities in April, the most in data going back to 2005, and comes after selling JPY1.2 trln in March.

Concerns about China’s financial stability remain high. Chinese regulators have reportedly instructed major creditors of China Evergrande Group to conduct a fresh round of stress tests on their exposure to the indebted property developer. According to press reports, the Financial Stability and Development Committee recently told lenders including ICBC to assess the potential hit to their capital and liquidity ratios if Evergrande were to run into trouble. Evergrande officials denied the story and added that its operations remain normal, echoing a statement earlier this week. Of note, the PBOC in 2018 pointed to Evergrande, HNA Group, Tomorrow Holding, and Fosun International as businesses that pose systemic risks to China’s financial system. In addition, Evergrande’s $20 bln of offshore bonds makes it one of the biggest Chinese issuers of dollar debt along with Huarong.

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