Dollar Consolidates Ahead of BOE Decision

August 04, 2022

Win Thin

Fed officials continue to push back against the perceived pivot; U.S. yields have surged as a result; ISM reported firm services PMI readings for July; Brazil hiked rates 50 bp to 13.75%, as expected
Germany reported weak June factory orders; ECB tightening expectations remain depressed; BOE is expected to hike rates 50 bp to 1.75%; Czech National Bank is expected to hike rates 25 bp to 7.25%
Australia reported firm June trade data

The dollar is consolidating its recent gains ahead of the BOE decision. DXY traded as high as 106.819 yesterday but has since fallen back to trade near 106.20 currently. Clean break above 106.518 sets up a test of the July 27 high near 107.246. The euro remains heavy below $1.02 and is on track to test the July 27 low near $1.0095, weighed down by the weak eurozone outlook and lower ECB tightening expectations. Sterling is slightly bid ahead of the BOE decision (see below) but we believe it is still on track to test the July 29 low near $1.2065. USD/JPY traded as high as 134.55 yesterday and is currently trading near 134.25. We maintain our strong dollar call as Fed officials are making it clear that markets misread the Fed’s commitment to lowering inflation. The greenback is also getting more traction after yesterday’s data came in stronger than expected. Tomorrow’s jobs data will likely be key for the medium-term dollar outlook.

AMERICAS

Fed officials continue to push back against the pivot. One after another, they stuck with the script that has been established. As we noted yesterday, what we are seeing is a coordinated and well-crafted communication effort by the Fed. It is meant to leave no doubt as to the Fed's intent to keep hiking rates until inflation comes down, no matter the cost to growth and employment. Mester is the only Fed speaker scheduled for today.

U.S. yields have surged as a result. The 2-year yield traded as high as 3.20% yesterday and is trading near 3.10% today, while the 10-year yield traded as high as 2.85% yesterday and is trading near 2.73% today. Of note, the 2-year differentials with Germany, the U.K., and Japan continue to edge higher and that’s dollar-positive. While yields are sharply higher, the needle hasn't moved much in terms of Fed expectations, as the swaps market still sees a terminal Fed Funds rate of 3.5% Eventually, we think this will adjust higher to something closer to Evans' 3.75-4.0% call. Stay tuned.

Bullard led off by reiterating his comments from yesterday. He said “We still have some ways to go here to get to restrictive monetary policy. I’ve argued now with the hotter inflation numbers in the spring, we should get to 3.75-4.0% this year. Exactly whether you want to do that at a particular meeting or some other meeting is a great question. I’ve liked front-loading. I think it enhances our inflation-fighting credentials.” He added that “We’re going to have to see convincing evidence across the board of headline and other measures of core inflation all coming down convincingly before we’ll be able to feel like we’re doing enough.” He then stressed that the Fed will probably have to keep rates “higher for longer” in order to succeed in bringing inflation down.

Daly did the same. She noted that “we’re not even up to neutral right now” and added that her estimated of neutral is “a little over 3%, maybe 3.1%.” She added that 3.4% is a “really reasonable place to get to by year-end,” which is consistent with the June Dot Plots. Daly said 50 bp “would be the reasonable thing to do in September” and added that rates would remain high more than 6-12 months. Daly stressed again that the Fed won’t bring rates down after just a few months, adding that markets are getting ahead of themselves with regards to Fed easing expectations. Looking beyond her call for 50 bp in September, Daly is sounding hawkish and is pretty clear in saying that rates have some ways to go and will stay there for longer than market is expecting.

We completely agree. This current situation is very different than what we had in mid-2019, when the Fed embarked on a so-called mid-cycle adjustment and cut rates 3 times for a total of 75 bp. Headline CPI then was hovering just below 2%, while core PCE was just around 1.7%. The Fed then was able to goose the economy a bit in order to ensure its full employment mandate because it was meeting its inflation mandate. Now, the Fed has met its employment mandate and so must give 100% effort to its inflation mandate.

Barkin signaled that the Fed is willing to pay a price for getting inflation down. He said “There is a path to getting inflation under control. But a recession could happen in the process. If one does, we need to keep it in perspective: No one canceled the business cycle.” Barkin added that “We may or may not get help from global events and supply chains, but we have the tools, and we have the credibility with households, businesses and markets required to deliver that outcome over time and we will.” He added that recession fears “are a little inconsistent with an economy adding almost 400,000 jobs a month and with unemployment near its historic low at 3.6%.” However, Barkin said he understands the concerns, noting that 8 of the last 11 Fed tightening cycles have led to recession.

Uber-dove Kashkari pretty much said the same. He stressed that “We are laser-focused on getting inflation down, and whether we are technically in a recession right now or not, doesn’t change my analysis. I’m focused on inflation.” When asked about market pricing for rate cuts in 2023, Kashkari said “I don’t want to say it’s impossible, but it seems like that’s a very unlikely scenario. The more likely scenario is we would continue raising and then we would sit there until we have a lot of confidence that inflation is well on its way back down to 2% before we would start to cut.” Regarding a soft landing, Kashkari said “I think it’s possible, but I don’t know how likely it is. And we’ll do everything we can to try to achieve it.”

ISM reported firm services PMI readings for July. Headline came in at 56.7 vs. 53.5 expected and 55.3 in June. Activity rose to 59.9 vs. 56.1 in June and was the highest since January. Employment rose to 49.1 vs. 47.4 in June, while prices paid fell to 72.3 vs. 80.1 in June. This was very similar to what we saw for ISM manufacturing PMI earlier this week. Elsewhere, June factory orders jumped 2.0% m/m vs. 1.2% expected and a revised 1.8% (was 1.6%) in May. For now, the U.S. economy remains resilient despite some growing pockets of weakness. This should give the Fed confidence to continue hiking rates aggressively. July Challenger job cuts, June trade data, and weekly jobless claims will be reported today. Elsewhere, Canada reports June building permits and trade data.

Brazil COPOM hiked rates 50 bp to 13.75%, as expected. However, it hinted at more tightening ahead as “The Committee will evaluate the need for a residual adjustment, of lower magnitude, in its next meeting. The COPOM emphasizes that it will remain vigilant and that future policy steps could be adjusted to ensure the convergence of inflation towards its targets.” IPCA inflation came in at 11.39% y/y in mid-July, the lowest since March but still well above the 2-5% target range. If inflation continues to fall, we believe Brazil is nearing the end of the cycle. However, the central bank is wary of persistent price pressures from fiscal stimulus ahead of the October elections, noting that “The Committee assesses that the possibility that fiscal policies that support aggregate demand become permanent heightens the upside risks of the inflationary scenario.” The swaps market is now pricing in 75 bp of tightening over the next 3 months that would see the policy rate peak near 14.5%, up from 14.0% at the start of this week.

EUROPE/MIDDLE EAST/AFRICA

Germany reported weak June factory orders. Orders were expected at -0.9% m/m but instead came in at -0.4% vs. a revised -0.2% (was 0.1%) in May. The y/y fell sharply to -9.0% vs. a revised -3.2% (was -3.1%) in May. June IP will be reported Friday and is expected at -0.3% m/m vs. 0.2% in May. German sentiment and survey indicators have been weakening for several months and now the hard data is following suit. With energy shortages becoming more likely this fall and winter, the German economy is likely to slip further into recession.

ECB tightening expectations remain depressed. WIRP suggests 50 bp hikes are no longer fully priced in for the next meetings September 8 and October 27. Looking ahead, the swaps market is now pricing in 125 bp of tightening over the next 12 months that would see the deposit rate peak near 1.25%.

Bank of England is expected to hike rates 50 bp to 1.75%. The markets will be looking for clues to future policy, but some of the major central banks have tried to limit forward guidance recently for fear of getting handcuffed if the data were to shift significantly. Updated macro forecasts will be released and it will be interesting to see if the bank still forecasts a shallow recession next year or a deeper one. Of note, 50 bp hikes are no longer fully priced in for the subsequent meetings September 15 and November 3. Looking ahead, the swaps market is pricing in 175 bp of tightening over the next 6 months that would see the policy rate peak near 3.0%, up from 2.75% at the start of this week. Chief Economy Pill speaks tomorrow.

Czech National Bank is expected to hike rates 25 bp to 7.25%. However, the market is split as nearly half the analysts polled by Bloomberg look for no hike and a couple look for a 50 bp hike. At the last meeting June 22, the bank delivered a hawkish surprise and hiked rates 125 bp to 7.0%. CPI rose 17.2% y/y in June, the highest since December 1993 and further above the 1-3% target range. The economy is slowing from a combination of rate hikes and slower eurozone growth and so the bank is nearing the end of its tightening cycle. We don’t think we are quite there yet but the messaging today will be key.

ASIA

Australia reported firm June trade data. Exports rose 5% m/m vs . flat expected and 9% in May while the y/y rate improved to 41.4% vs. 37.7% in May. On the other hand, imports rose 1% m/m vs. 3% expected and a revised 5% (was 6%) in May while the y/y rate slowed slightly to 33.5% vs. 34.9% in May. As a result, the trade surplus jumped to a record high AUD17.7 bln. The external sector should boost Q2 growth, which won’t be reported until September 7, a day after the next RBA meeting. The bank jut hiked 50 bp but seemed to pivot to a slower pace going forward. WIRP suggests a 25 bp hike then is fully priced in, with only around 30% odds of a larger 50 bp move. Looking ahead, the swaps market is pricing in 150 bp of tightening over the next 12 months that would see the policy rate peak near 3.35%.

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