Dollar Firm as China Triggers Risk-off Impulses

August 15, 2022

Win Thin

Markets are starting the week in risk-off mode; Fed tightening expectations continue to adjust; regional Fed manufacturing surveys for August will start rolling out
Reports suggest BOE Governor Bailey would be “open to a review” of the bank’s mandate; the BOE is set to continue tightening as inflation spirals ever higher; Israel reports July CPI
Japan reported firm Q2 GDP data; China reported weak July IP and retail sales; PBOC delivers surprise rate cut

The dollar is bid as risk-off impulses were triggered by China (see below). DXY is up for the second straight day and is trading near 106.30 currently. Lat week’s euro rally ran out of steam near $1.0360, which is the 62% retracement objective of the June-July drop. After failing to break that level twice, the euro is currently trading back below $1.02. Sterling is currently trading near $1.2060 and the break below $1.2110 sets up a test of the August 5 low near $1.20. USD/JPY is trading flat near 133.40 despite the risk-off backdrop. A break above 134.10 is needed to set up a test of the August 8 high near 135.60. The commodity currencies and EM FX are underperforming due to the poor data out of China (see below). We maintain our strong dollar call as the dollar smile seems intact. Once this risk-off period ends, the dollar should still benefit from the relatively strong U.S. economic outlook. However, we acknowledge that a period of consolidation is possible likely to be seen until markets readjust Fed tightening expectations higher.

AMERICAS

Markets are starting the week in risk-off mode. Weak Chinese data and a surprise PBOC rate cut are the triggers, though concerns about global growth are really nothing new. The dollar is benefitting, while the commodity currencies and EM FX are underperforming. The yen and the U.S. 10-year yield are surprisingly unchanged, while oil and copper prices are sharply lower. These periodic risk-off episodes typically wear off after several days but we expect these episodes to reappear more and more frequently in the coming months. Quite simply put, the markets have gotten too complacent about global slowdown risks and the global tightening cycle. Both are likely to be worse than what markets are pricing in and so the eventual repricing will lead to periodic (and violent) market dislocations. Stay tuned.

Fed tightening expectations continue to adjust. WIRP suggests a 50 bp hike is fully priced in for the September 20-21 FOMC meeting, with 55% odds of a 75 bp hike. Looking ahead, the swaps market is now pricing in a 3.75% terminal rate vs. 3.5% at the start of last week. We think that market expectations are finally reacting to the Fed’s recent messaging and if the market eventually gives the Fed 75 bp next month, the Fed will take it. The market is still pricing in a quick turnaround by the Fed into an easing cycle in H1 2023. It's pretty clear that the Fed doesn't see it that way and the data bear that out, at least for now. Market should also reprice these easing expectations in the coming days and weeks.

Regional Fed manufacturing surveys for August will start rolling out. Empire survey kicks things off today and is expected at 5.0 vs. 11.1 in July. Philly Fed reports Thursday and is expected at -5.0 vs. -12.3 in July. In between, July IP will be reported Tuesday and is expected at 0.3% m/m vs. -0.2% in June. It’s clear that the U.S. manufacturing sector is slowing but that is what the Fed is trying to engineer with its rate hikes. The sector continues to expand, at least for now. August NAHB housing index and TIC data also will be reported.

EUROPE/MIDDLE EAST/AFRICA

Reports suggest Bank of England Governor Bailey would be “open to a review” of the bank’s mandate. Press reports suggest Bailey said this during a phone call with Chancellor Zahawi on August 4. The likely next Prime Minister Truss has been very critical of the BOE’s performance and has promised a review of its mandate. While Truss has promised to maintain the bank’s independence, it is impossible not to view such a move as political meddling in the sphere of monetary policy. The recent Fed and ECB framework reviews were decided on internally, not by an outside body. Any hint of political interference would be very negative for sterling and gilts

The BOE is set to continue tightening as inflation spirals ever higher. WIRP suggests a 50 bp hike September 15 is nearly 90% priced in. The swaps market is pricing in 150 bp of tightening over the next 12 months that would see the policy rate peak near 3.25%, up from 3.0-3.25% at the start of last week. July CPI data Wednesday should help fully cement expectations of a 50 bp hike next month, with headline expected at 9.8% y/y vs. 9.4% in June.

Israel reports July CPI. Headline is expected at 4.6% y/y vs. 4.4% in June. If so, it would be the highest since October 2008 and further above the 1-3% target range. The central bank last hiked rates 50 bp to 1.25% July 4, the first 50 bp hike since 2011. The bank noted that “The Israeli economy is recording strong growth, accompanied by a tight labor market and an increase in the inflation environment.” It also stopped referring to the tightening cycle “gradual” and sees the policy rate at 2.75% in Q2 2023. Next meeting is August 22 and another 50 bp hike seems likely. Q2 GDP data will be reported Tuesday, with annualized growth expected at 2.2% vs. -1.8% in Q1.

ASIA

Japan reported firm Q2 GDP data. Annualized growth came in at 2.2% vs. 2.6% expected and a revised 0.1% (was -0.5%) in Q1. Private consumption and business spending contributed to growth, while inventories subtracted from and net exports were neutral for growth. Of note, Japan’s GDP is now back to pre-pandemic levels but trailed both the U.S. and the eurozone in getting there. Despite the recovery, policymakers should remain concerned about H2 as virus numbers have risen sharply in Q3 and have weighed on some parts of the economy. For now, the data support the bank’s decision to maintain ultra-loose policy. Next BOJ policy meeting is September 21-22 and no change is expected then.

China reported weak July IP and retail sales. IP came in at 3.8% y/y vs. 4.3 expected and 3.9% in June, while sales came in at 2.7% y/y vs. 4.9% expected and 3.1% in June. The economy is picking up in H2 as lockdowns ease but the downside miss to the data supports our view that the recovery will be uneven as more outbreaks are seen. The PBOC unexpectedly set its 1-year MLF rate 10 bp lower to 2.75% vs. steady rates expected. This was very surprising as just last week, the PBOC pivoted more hawkish by downplaying the need for any further monetary easing due to rising inflation risks. That came despite much weaker than expected July new loan and aggregate financing data. Today’s rate cut suggests policymakers are in fact alarmed about weaker growth and further easing measures have now become more likely. However, it still seems clear that economy won’t get close to this year’s growth target of “around 5.5%.” Lastly, the monetary policy divergence theme remains alive and well, which points to further yuan weakness.

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