Dollar Continues to Firm as an Eventful Week Begins

October 31, 2022

Win Thin

U.S. yields are edging higher ahead of the FOMC meeting; key October survey data will be reported; former Brazilian President Lula won in a very close second round vote
Eurozone October CPI came in hot; eurozone also reported Q3 GDP data; U.K. Office for National Statistics confirmed that the proposed energy price caps will reduce inflation; BOE is expected to hike rates 75 bp to 3.0% Thursday
Reports suggest the BOJ recently spent JPY6.35 trln ($43 trln) supporting the yen; Japan reported September IP and retail sales; Australia reported September retail sales and private sector credit; China reported soft official October PMI readings

The dollar continues to rise as an eventful week begins. DXY is up for the third straight day and has recouped over a third of its late October swoon. Next major retracement objectives come in near 111.739 and 112.259. The yen is leading this move and a break above 149.35 would set up a test of the USD/JPY high near 152 from October 21. Data suggest the BOJ cannot maintain a heavy pace of intervention (see below). The euro remains heavy despite higher than expected CPI data today. A break below $0.9855 is needed to set up a test of the October 21 low near $0.9705. Sterling has held up relatively better ahead of the BOE decision and is trading near $1.1555. The combination of ongoing risk off impulses and continual repricing of Fed tightening risks is likely to see the dollar continue to recover after this recent correction. Much will depend on the Fed and how the U.S. data come in this week but so far, the signs are positive for the greenback.

AMERICAS

U.S. yields are edging higher ahead of the FOMC meeting. The 2-year yield traded as low as 4.26% Friday but has since recovered to around 4.48% currently. Likewise, the 10-year yield trade as low as 3.91% Friday but has since recovered to around 4.06% currently. The dollar and yields often fare poorly during the Fed media blackout as notions of a pivot have picked up in the absence of any hawkish Fed commentary. We think the markets will get a dose of reality from the FOMC this week. Of note, the 3-month to 10-year curve has flipped back to a positive slope of 2 bp after inverting last week to -8 bp. WIRP suggests a 75 bp hike is fully priced in, while the swaps market is pricing in a terminal rate of 5%. We think Fed tightening expectations still have room to adjust and so this curve could easily flip back to being inverted. Regardless, the signal is impossible to ignore and that is the U.S. economy is moving closer to recession within the next 12 months, give or take.

Key October survey data will be reported. Chicago PMI will be reported today and is expected at 47.0 vs. 45.7 in September. The Fed regional manufacturing surveys also wrap up today with Dallas expected at -18.5 vs. -17.2 in September. ISM manufacturing PMI will be reported tomorrow and is expected at 50.0 vs. 50.9 in September. Keep an eye on prices paid and employment, which stood at 51.7 and 48.7 in September, respectively. ISM services PMI will be reported Thursday and is expected at 55.1 vs. 56.7 in September. Keep an eye on prices paid and employment, which stood at 68.7 and 53.0 in September, respectively. Last week, S&P Global reported soft preliminary October PMI readings. Manufacturing came in at 49.9 vs. 52.0 in September, services came in at 46.6 vs. 49.3 in September, and the composite came in at 47.3 vs. 49.5 in September. However, it’s worth noting that the ISM readings have been running higher than S&P Global in recent months and appear to be more closely reflecting the resilience of the U.S. economy.

Former Brazilian President Lula won in a very close second round vote. Like the first round, the vote was much closer than polls suggested as he eked out a 50.9-49.1% win over current President Bolsonaro. The slim margin of victory for Lula suggests that he will have to rule from the center, which is overall positive. As of this writing, Bolsonaro has yet to speak or concede. We think markets will react cautiously because there is a risk that President Bolsonaro does not recognize the results. If he doesn’t, there is scope for social unrest. If Bolsonaro accepts the results, then we think Brazil assets will see a brief relief rally. That said, the overall global backdrop for EM remains negative due to rising global interest rates and rising global recession risks. Brazil may enjoy a brief positive knee-jerk bounce but a sustainable rally depends on EM as a whole recovering. We think that is a 2023 story as we need to see peak Fed Funds rate and also get a better idea of how deep the global slowdown will be.

EUROPE/MIDDLE EAST/AFRICA

Eurozone October CPI came in hot. Headline came in at 10.7% y/y vs. 10.3% expected and 9.9% in September, while core came in as expected at 5.0% y/y vs. 4.8% in September. There were clear upside risks after the country data Friday from Germany, France, and Italy showed sharp accelerations from September. These readings will keep pressure on the ECB to continue tightening aggressively even as the eurozone slips into recession. As a result, ECB tightening expectations remain heightened. The bank just hiked rates 75 bp last week and WIRP suggests another 75 bp is about 55% priced in for December 15. The swaps market is pricing in a peak policy rate near 3.75%, which is a new cycle high. The problem is that the eurozone is already tipping into recession even as the ECB tightens aggressively.

Eurozone also reported Q3 GDP data. GDP came in at 0.2% q/q vs. 0.1% expected and 0.8% in Q2 while the y/y rate came in as expected at 2.1% vs. 4.1% in Q2. The slowdown is unmistakable and ECB President Lagarde warned last week that the economy is likely to slow further in Q4 and Q1. Elsewhere, Germany reported firm September retail sales. Sales came in at 0.9% m/m vs. -0.5% expected and -1.8% in August. Still, Germany remains the weak link in the eurozone but the rest are already following it into recession. France has held up surprisingly well but is also weakening.

The U.K. Office for National Statistics confirmed that the proposed energy price caps will reduce inflation. ONS said it will use the capped price of energy that consumers pay instead of the total price when it calculates its various inflation measures. As things currently stand, the guarantee caps the unit price of energy in order to cap household energy costs at GBP2,500. Businesses are also receiving similar support and the Treasury currently estimated the cost of the two programs at more than GBP60 bln. Truss’ Chancellor Kwarteng announced the program in the September mini-budget and was to last for two years, but new Chancellor Hunt cut the time period back to six months. Of note, Hunt has delayed his budget statement until November 17. The unveiling was originally planned for this week but we do not take any issue with its delay. The budget will be a key factor in regaining market credibility and so there is no need to rush it. Contrast this to the approach taken by Kwarteng, who announced his ill-conceived mini-budget without consulting the cabinet nor the OBR.

Bank of England is expected to hike rates 75 bp to 3.0% Thursday. Updated forecasts will be released at this week’s meeting and while there is still some fiscal uncertainty, the bank may be able to incorporate a rough framework of the fiscal plan to be unveiled later this month by Chancellor Hunt. If nothing else, the coordination and communication between the BOE and the government can only improve from the Truss lows. Of note, Quantitative Tightening (QT) will begin tomorrow but longer-dated gilts will be excluded. Look for some guidance from the bank when this exclusion might end. Looking ahead, the swaps market is pricing in 250-275 bp of tightening over the next 12 months that would see the policy rate peak between 4.75-5.0%, down sharply from 6.25% right after the mini-budget in late September.

ASIA

Reports suggest the Bank of Japan recently spent JPY6.35 trln ($43 trln) supporting the yen. This estimate covers the period between September 29 and October 27 and is more than double the estimated JPY2 84 trln ($19.7 bln) it spent defending the yen earlier in September. In total, these interventions represent nearly 6% of its total foreign reserves and so it’s clear that this pace cannot be sustained on a regular basis. Rather, we think the BOJ will continue to intervene sporadically and quietly to try and keep the markets guessing. With the BOJ delivering another dovish hold last Friday, we think USD/JPY remains a buy at current levels. The pair has retraced around half of the intervention-related drop in late October and a break above 149.35 would set up a test of the October 21 high near 152.

Japan reported September IP and retail sales. IP came in at -1.6% m/m vs. -0.8% expected and 3.4% in August, while sales came in at 1.1% m/m vs. 0.8% expected and 1.3% in August. The y/y rates improved as the economy continues to recover but policymakers remain concerned about growing headwinds. Why else would the government order another extra budget to the tune of JPY29.1 trln ($199 bln) to fund new stimulus last week even as the BOJ maintained its ultra-loose policy?

Australia reported September retail sales and private sector credit. Sales came in at 0.6% m/m vs. 0.5% expected and 0.6% in August, while credit came in as expected at 0.7% m/m vs. 0.8% in August. Data come ahead of the Reserve Bank of Australia decision tomorrow when it is expected to hike rates 25 bp to 2.85%. A handful of analysts polled by Bloomberg look for a larger 50 bp move. At the last policy meeting October 4, it hiked rates 25 bp to 2.60% vs. 50 bp expected. Governor Lowe stated then that “The cash rate has been increased substantially in a short period of time. Reflecting this, the Board decided to increase the cash rate by 25 bp this month as it assesses the outlook for inflation and economic growth in Australia.” Since that meeting, inflation has come in even hotter with CPI rising 7.3% y/y in both September and Q3, both cycle highs. The newly created monthly core CPI also ran hot at a cycle high 6.8% y/y. New macro forecasts will be released Friday in the RBA’s Statement on Monetary Policy. Of note, the swaps market sees the policy rate peaking near 4.40%.

China reported soft official October PMI readings. Manufacturing came in at 49.2 vs. 49.8 expected and 50.1 in September, while non-manufacturing came in at 48.7 vs. 50.1 expected and 50.6 in September. This ragged the composite down to 49.0 vs. 50.9 in September to the lowest since May. Caixin reports its manufacturing PMI tomorrow and is expected at 48.5 vs. 48.1 in September. Caixin reports its services and composite PMI readings Thursday, with services expected at 49.0 vs. 49.3 in September. The recovery will remain uneven as China continues its Covid Zero policy. Fresh lockdowns were imposed late last week in Wuhan, Guangzhou, Beijing, and Shanghai, underscoring President Xi’s unwavering commitment to this controversial policy.

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