Dollar Firm Ahead of FOMC Decision

July 28, 2021
  • The two-day FOMC meeting ends with a decision this afternoon; Powell and company face a delicate balancing act; U.S. data continue to come in firm; Canada reports June CPI
  • German GfK consumer confidence for August was reported; U.K. has softened its travel rules
  • Australia reported Q2 CPI; the sell-off in Asia stocks continued overnight

Ahead of the FOMC decision today, we decided to revisit the state of rates and carry in EM. We are not too worried about a surprise increase in U.S. yields hitting EM assets, but approaching tightening (or tapering) events by the Fed always put investors on edge. The good news is that many EM are well ahead of DM central banks in the cycle and many have already built up considerable carry buffers. Some of the typical “high-yield” currencies (BRL, MXN, ZAR, and RUB) all have 3-month implied rates between 5.5-6.5%. By no means does this ensure outperformance of these currencies; in fact, we think they are likely to underperform in the medium them, but the high carry does provide a level of comfort that they won’t fall too far behind.

The dollar is firm ahead of the FOMC decision this afternoon. DXY is up for the first time after two straight down days and is trading around 92.50. If we get a modestly hawkish hold today, it should eventually test the March 31 high near 93.437. The euro was finally able to make a clean break above $1.18 yesterday but has since drifted lower to test support there today. Sterling made a clean break above $1.38 yesterday and has managed to hang on to those gains, and so the EUR/GBP cross is trading at the lowest level since April 6 near .8500. USD/JPY is seeing buying interest below 110 and should move higher as risk sentiment improves.

AMERICAS

The two-day FOMC meeting ends with a decision this afternoon. We expect a modestly hawkish hold, as the Fed is likely to acknowledge ongoing inflation risks and continues with its discussions of tapering. Tapering could be mentioned in the official statement, which would be a very hawkish surprise. There won’t be updated macro forecasts or Dot Plots until the September FOMC meeting. Because this is widely seen as a placeholder meeting, we think markets will be susceptible to surprises at either end of the hawk/dove spectrum. We lean toward a hawkish surprise, in which case the dollar rally should continue. In our view, the risks of being too dovish outweigh the risks of being too hawkish at this juncture for the Fed.

Powell and company face a delicate balancing act. Fed policymakers must acknowledge that inflation is going to be higher than expected for longer than expected, and that they are ready to act if needed to control it. Inflation breakeven rates have been creeping higher this week, pressuring real yields lower. On the other hand, the Fed should also acknowledge that the state of the pandemic remains highly uncertain due to the spread of the delta variant, though we believe the U.S. economy is likely to prove quite resilient.

Indeed, U.S. data continue to come in firm. Yesterday, June durable goods orders rose 0.8% m/m vs. 2.2% expected. However, May was revised up to 3.2% m/m vs. 2.3% previously. Elsewhere, Conference Board consumer confidence rose to 129.1 vs. 123.9 expected and a revised 128.9 (was 127.3) in June. The rise was surprising, as University of Michigan consumer sentiment fell to 80.8 vs. 86.5 expected and 85.5 in June. Lastly, Richmond Fed manufacturing index rose to 27 vs. 20 expected and a revised 26 (was 22) in June. When all is said and done, the U.S. economy remains strong. June wholesale/retail inventories and advance goods trade data (-$88 bln expected) will be reported today.

Canada reports June CPI. Headline inflation is expected to ease to 3.2% y/y vs. 3.6% in May, while common core is expected to rise a tick to 1.9% y/y. The Bank of Canada delivered another round of tapering July 14 and reaffirmed that the first rate hike is likely to be in H2 22. It also revised up its growth and inflation forecasts. Inflation is now seen at 3.0% (2.3% previously) in 2021, 2.4% (1.9%) in 2022, and 2.2% (2.3%) in 2023. These forecasts show that the current rise in inflation is seen as temporary. Next policy meeting is September 8 and no change is expected then.

EUROPE/MIDDLE EAST/AFRICA

German GfK consumer confidence for August was reported. It was expected to improve to 1.0 but instead remained steady at -0.3. Earlier this week, IFO business sentiment unexpectedly declined to 100.8 in July from 101.7 in June. These trends bear watching and underscore why the ECB remains concerned about the durability of the recovery.

The U.K. has softened its travel rules. The government decided to allow for fully vaccinated EU and U.S. travelers to enter the country without having to quarantine. This is positive for tourism-related sectors of the U.K. economy. However, the U.S. is unlikely to reciprocate any time soon since just last week, it advised Americans to avoid traveling to the U.K. because of the surge in coronavirus infections. Those numbers have since eased but the impact of last Monday’s Freedom Day has yet to be determined. New cases declined for a seventh straight day, but deaths rose to the highest since mid-March.

ASIA

Australia reported Q2 CPI. Headline inflation came in a tick higher than expected at 3.8% y/y vs. 1.1% in Q1, while trimmed mean came in as expected at 1.6% y/y vs. 1.1% in Q1. Q2 PPI will be reported Friday. The RBA tapered QE at the July 6 meeting even as Governor Lowe repeated existing forward guidance that inflation is unlikely to return sustainably to the central bank’s 2-3% target for some time, and that “we do not expect the cash rate to be increased until 2024 at the earliest.” While the headline reading is eye-catching, the trimmed mean would seem to support the RBA’s cautious outlook. Dovish minutes of that meeting showed that “Given the high degree of uncertainty about the economic outlook, members agreed that there should be flexibility to increase or reduce weekly bond purchases in the future.” Next policy meeting is August 3 and no change is expected then. Some local banks are looking for the RBA to reverse its decision to taper in H2, but August seems too soon for such a pivot.

The sell-off in Asia stocks continued overnight, but at least it hasn’t accelerated. We don’t have a lot to add here aside from the well understood tech-sector crackdown in China and the festering issue of the giant property company Evergrande. The company suffered further ratings downgrades this week and didn’t pay a special dividend owed to investors, all of which have propelled it’s 2025 USD bond to 35% yield. On the equity front, the Shanghai Composite was down for the fourth consecutive session (0.6%), while the Hang Seng and the Kospi managed small gains. Most other indices in the region were down about to the tune of 0.5%.

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