Dollar Firm Ahead of ECB Decision

October 28, 2021
  • The U.S. yield curve continues to flatten; reports suggest a fiscal deal will be announced by President Biden today; regional Fed manufacturing surveys for October will wrap up; we get our first look at Q3 GDP; weekly jobless claims will be watched closely; BOC delivered a hawkish hold; Brazil hiked rates 150 bp to 7.75%, as expected
  • ECB decision will be out shortly and a dovish hold is expected; the euro tends to weaken on recent ECB decision days; U.K. Chancellor Sunak’s budget speech contained few surprises; when all is said and done, strong U.K. growth and higher inflation have boosted revenues and narrowed the budget deficit
  • Two-day Bank of Japan meeting ended with a dovish hold; after the BOC’s hawkish hold, all eyes now turn to the RBA as markets continue to test its YCC

The dollar is up modestly ahead of the ECB decision. DXY is trading just below 94.0, which is the top of the trading range that has largely held since mid-October. The euro is trading heavy just below $1.16 as markets are set up for a dovish ECB, while sterling is trading flat near $1.3750 in the wake of Sunak’s budget speech (see below). USD/JPY is trading heavy near 113.50 despite a dovish hold from the BOJ (see below). We expect U.S. yields and the dollar to continue rising. For DXY, we need a break above 94.15 to set up a test of the October 12 high near 94.561. For EUR, we need a break below $1.1580 to set up a test of that day's low near $1.1525.


The U.S. yield curve continues to flatten. After peaking at 166 bp last week, the 3-month to 10-year curve is currently just below 150 bp. The 2- to 10-year curve has flattened even more, falling to just below 100 bp currently from a peak near 130 bp earlier this month. The 2-year yield traded today near 0.56%, a new cycle high. However, the 10-year yield is trading near 1.54% and is at the low end of recent ranges. Fed lift-off is now fully priced in for Q3 22, with a second hike fully priced in for Q4 22. Odds of Q2 22 lift-off have risen significantly, which strikes us as a bit too aggressive given tapering is unlikely to end until mid-2022. That said, U.S. economic data remain firm and so we believe the upward trajectory in rates and the dollar remains intact.

Reports suggest a fiscal deal will be announced by President Biden today. He will address House Democrats first before delivering a speech to the public from the White House later. So far, the specifics of the deal are unknown as officials are keeping a tight lip, but Biden himself set expectations recently for a deal between $1.75-1.90 trln. Our base case has always been that some sort of compromise would be reached, but the likely price tag has fallen dramatically from what we initially expected to be in the $2.5 trln area. If true, the deal on the “human infrastructure” bill would pave the way for a quick vote on the $550 tradition infrastructure bill, which has bipartisan support. This fiscal stimulus should keep upward pressure on U.S. yields.

Regional Fed manufacturing surveys for October will wrap up. Kansas City Fed survey closes things out today and is expected at 20 vs. 22 in September. So far, Richmond Fed manufacturing survey came in at 12 vs. -3 in September, Dallas Fed came in at 14.6 vs. 4.6 in September, Empire survey came in at 19.8 vs. 34.3 in September, and Philly Fed survey came in at 23.8 vs. 30.7 in September. Most of these readings have been at historically high levels and so some moderation is to be expected.

We get our first look at Q3 GDP. Consensus sees growth of 2.6% SAAR, down sharply from 6.7% in Q2. The Atlanta Fed’s GDPNow model is tracking a measly 0.2% SAAR for Q3, down from 0.5% previously. The next update to the model will be this Friday. While the NY Fed has temporarily suspended its Nowcast model due to pandemic-related volatility in the data, its Weekly Economic Index suggests some upside risks to Q3 growth. Of note, Bloomberg consensus sees growth picking up to 4.9% SAAR in Q4 before falling back a bit to 4.0% in Q1 and 3.6% in Q2. These are still enviable rates of growth.

Weekly jobless claims will be watched closely. That’s because the continuing claims data are for the BLS survey week containing the 12th of the month. These are expected at 2.42 mln vs. 2.481 mln the previous week. Last week, initial claims for the BLS survey week came in at 290k vs. 296k previously. This week, they are expected at 288k. Both are at pandemic lows and support our view that the labor market continues to heal. Of note, the consensus forecast for October NFP stands at 395k currently vs. 194k in September. Pending home sales (0.5% m/m expected) will also be reported.

Bank of Canada delivered a hawkish hold. Rates were kept steady at 0.25% and a final round of tapering was delivered, both as expected. The surprise was that the bank now sees the output gap closing in Q2 22, moving up from H2 22 previously. This validates recent market pricing that saw lift-off moving forward. The swaps market is now pricing in more than 125 bp of hikes over the next 12 months, which is very hard to reconcile with the new forward guidance. Updated macro forecasts see slower growth this year and next, while inflation forecasts were raised for the entire horizon.

The list of hawkish major central banks continues to grow, with BOC joining RBNZ, Norges Bank, and BOE in this group. Yes, these are all small fry but we think they will prove to be canaries in the coal mine that have foreshadowed Fed tapering and eventual lift-off. We still don't think markets are fully positioned for what the Fed’s speed tapering ($120 bln per month of QE will fall to zero over six months) and liftoff (Q3 22 fully priced in with another Q4 22 hike priced in) will do to global liquidity. This is on top of all the small fry in DM and EM tightening policy aggressively as well.

Brazil COPOM hiked rates 150 bp to 7.75%, as expected. There was some talk of a 175 bp hike but we always felt that was too aggressive. The bank said “Given the deterioration of the balance of risks and the increase in its inflation projections, this pace is the most appropriate to guarantee inflation convergence to the targets at the relevant horizon,” which suggests another hike of the same magnitude at the next meeting December 8 that would take the policy rate up to 9.25%. After that, the swaps market is pricing in another 375 bp of tightening over the next six months that would take the policy rate to 13.0%.


European Central Bank decision will be out shortly and a dovish hold is expected. Madame Lagarde has already flagged this meeting as a placeholder, with the difficult decision on QE to come at the December 16 meeting. That said, there will clearly be a lively debate about inflation (transitory or something more sustainable) and policy. Even for the ECB, markets seem to be getting overly bulled up regarding tightening. Swaps market is pricing in 10 bp of ECB tightening over the next twelve months. While that seems miniscule, it was enough for some ECB officials to push back against this. The September ECB forecasts imply no liftoff before 2024 at the earliest. 2024 forecasts will be added at the December meeting and are likely to imply no liftoff before 2025.

Of note, the euro tends to weaken on recent ECB decision days. Of the past four, the euro has weakened on three of them. It is currently down on the day and if it closes weaker, then the streak will be four of the past five. The market is positioned for a dovish ECB and so there may be some “sell the rumor, buy the fact” price action afterwards. That said, the monetary policy divergence with the Fed is undeniable and so the fundamentals point to a weaker euro ahead. The 2-year U.S.-German rate differential is 117 bp, the highest since March 2020.

U.K. Chancellor Sunak’s budget speech contained few surprises. There were a ton of leaks and headlines but here are the key takeaways from Sunak's budget speech: 1) borrowing will fall to 1.5% of GDP by the end of the forecast horizon, 2) the 2021-22 budget deficit is forecast at -GBP 183 bln while Treasury plans to issue GBP194.8 bln of gilts vs. GBP219.6 bln previously forecast, 3) the economy is forecast to grow 6.5% in 2021 and 6.0% in 2022, 4) GBP75 bln of fiscal stimulus will be seen over the next six years, and 5) there will be a 6.6% increase in the national minimum wage. This overall fiscal stance should be seen as expansionary, even though deficits are forecasts to fall in the coming years. How is that possible?

When all is said and done, strong growth and higher inflation have boosted revenues and narrowed the budget deficit. There was no fiscal magic involved but either way, this allowed Sunak to include increased spending in his budget that are meant to help firms and families hurt by the pandemic. It may seem that Sunak can have his cake and eat it too, but this requires everything going right for the U.K. economy going forward. The biggest risk is that premature tightening (both fiscal and monetary) will choke off growth and slow revenues in 2022, and then all bets are off for the fiscal outlook. Of note, the IMF sees 5% UK growth in 2022, while the OECD sees 5.2% and we think risks are tilted to the downside.


Two-day Bank of Japan meeting ended with a dovish hold. As widely leaked, the BOJ lowered its inflation forecast for FY21 to 0% from 0.6% and cut the FY21 growth forecast to 3.4% from 3.8%. There were no changes to the FY22 and FY23 inflation forecasts, which suggest no liftoff before FY24 at the earliest. FY24 will be added with the April 2022 Outlook Report and is likely to show inflation remaining well below the 2% target, which would mean no liftoff until FY25 at the earliest. Governor Kuroda said there is low risk that inflation will accelerate like it has in the rest of the world, underscoring that the BOJ is nowhere near removing accommodation even as most other major central banks do. Kuroda noted that recent yen weakness was a positive for the economy. Japan also reported September retail sales. They were expected to rise 1.5% but instead rose nearly double that at 2.7% vs. -4.0% in August.

After the BOC’s hawkish hold, all eyes now turn to the RBA as markets continue to test its YCC. The yield on the targeted April 2024 bond has been pushed back up to nearly 0.54%, the highest since March 20. When the yield rose above the 0.10% target last week, the RBA responded last Friday with intervention that pushed the yield back below the target. Swaps market is now pricing in nearly 100 bp of RBA tightening over the next twelve months, up from less than 50 bp at the start of the week. Next policy meeting is November 2. While we believe the bank will push back against market expectations rather than validate them, we acknowledge that risks of a hawkish surprise have risen in light of the BOC’s actions. New macro forecasts will be released and will be a big part of whether the current forward guidance for liftoff in 2024 can be maintained.

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