- This is a huge week for central banks; U.S. yields continue to rise; Fed tightening expectations remain elevated
- ECB officials remain hawkish; Bundesbank noted growing risks of recession in Germany
- RBA acknowledged the negative impact of its rate hikes on the housing market; China officials continue to lean against yuan weakness
The dollar remains firm as a very eventual week begins. DXY is up for the third straight day and trading back above 110. With the Fed expected to remain hawkish (see below), we look for a test of last week’s cycle high near 110.786. The euro remains heavy and is trading just below parity. With the fundamentals deteriorating, we still look for a test of this month’s cycle low near $0.9865. U.K. markets are closed for the Queen’s funeral. Sterling also remains heavy and traded today near last week’s cycle low of $1.1350, the lowest since 1985. Charts point to a test of the February 1985 all-time low near $1.0520. Lastly, USD/JPY continues to trade sideways near 143.50 as last week’s BOJ rate check continues to dampen the upward trajectory of this pair. If the BOJ meeting ends with a dovish hold Thursday as we expect, yen weakness should resume. The repricing of Fed tightening risks is likely to keep the dollar bid across the board near-term. As we said during this most recent dollar correction lower, nothing has really changed fundamentally and the global backdrop continues to favor the dollar and U.S. assets in general.
This is a huge week for central banks. Not only is the Fed expected to hike rates 75 bp Wednesday, but several other major central banks are also delivering higher rates. The Riksbank is expected to hike rates 75 bp Tuesday, while the SNB is expected to hike 75 bp and the BOE and Norges Bank both by 50 bp Thursday. In EM, South Africa, Taiwan, the Philippines, and Indonesia are all expected to hike rate this week. Tighter global liquidity will lead to slower global growth and so the backdrop remains very negative for risk assets, especially EM. Even though other central banks are hiking, the Fed remains the leader and so the dollar should continue to gain.
U.S. yields continue to rise. The 2-year yield is trading at a new cycle high near 3.92%, while the 10-year yield is trading near the June 14 high near 3.50%. The real 10-year yield is trading near 1.11% and is on track to test the November 2018 cycle high near 1.15%. This generalized increase in U.S. yields should continue to support the dollar. Of note, the 3-month to 10-year curve remains positively sloped near 38 bp and so we are not yet ready to call for a recession in the U.S.
Fed tightening expectations remain elevated. WIRP suggests nearly 25% odds of a 100 bp hike Wednesday. While we favor 75 bp, we acknowledge risks of a hawkish surprise. With a 100 bp move, the Fed could send a very strong message to the markets that it is very serious about getting inflation back to target. Looking ahead, the swaps market is starting to price in a terminal rate of 4.75% over the next 12 months, up sharply in recent days and making new highs for this cycle. Indeed, we expect a hawkish shift in the Dot Plots, with the expected policy rate moving up to 4.0% in 2022 and up to 4.25-4.5% in 2023. For 2024, the expected rate is likely to remain steady in order to underscore that any sort of pivot is not foreseen, at least for now. Powell’s press conference will be key but we expect no deviation from the hawkish tone he delivered at Jackson Hole August 26 and reinforced at his only follow-up speech September 8. There should be a singular focus on taming inflation and no hints of a pivot.
ECB officials remain hawkish. Over the weekend, Nagel stressed that “If the data trend continues, more interest-rate increases have to follow -- that’s already agreed in the Governing Council. We have to be determined, in October and beyond.” He also said that “We’re still very far away from interest rates that are at a level that is appropriate given the current state of inflation. More needs to happen, rates have to go up -- by how much is still to be determined,” Elsewhere, Guindos said “We must reinforce all the elements that support the credibility of the central bank, avoiding second-round effects. The slowdown will not reduce inflation by itself. Monetary policy needs to contribute to ease inflation.” WIRP suggests 85% odds of another 75 bp at the next meeting October 27, while the swaps market is pricing in 200 bp of tightening over the next 12 months that would see the deposit rate peak near 2.75%.
The Bundesbank noted growing risks of recession in Germany. In its monthly report, the bank noted “There are increasing signs of a recession of the German economy in the sense of a clear, broad-based and longer-lasting decline in economic output.” It noted that limited energy shipments in particular are leading to rising inflation and increased uncertainty that is affecting both German companies and households. The bank added that stockpiled natural gas supplies will probably help to avoid formal energy rationing this winter, economic output is likely to decline “somewhat” in Q3 before a “noticeable” contraction in Q4 and Q1. Lastly, the Bundesbank believes the economy will probably be able to avoid the adverse scenario set forth in its June projections, which forecast an overall GGDP contraction of -3.2% next year but warned that the outlook is still “extremely uncertain.” September PMI readings out this Friday should confirm what markets already know, and that is Germany is already in recession.
The RBA acknowledged the negative impact of its rate hikes on the housing market. Head of domestic markets Jonathan Kearns noted that “Because higher interest rates reduce borrowing capacity and increase loan repayments, they typically result in a decline in new housing borrowing. The timing and strength of the relationship between interest rates and housing borrowing can vary, not least because the factors driving interest rates, such as income growth, can also directly affect housing demand, but there is no doubt that interest rates are an important determinant of housing finance.” The RBA has hiked rates a total of 225 bp so far and Kearns estimated that this would cut maximum loan sizes by about 20%. We note that the swaps market is pricing in another 165 bp of tightening over the next 12 months that would see the policy rate peak near 4.0%, which means even greater pain ahead for the Australian housing sector. Yet like what we are seeing here in the U.S., this is exactly what the RBA wants to see. WIRP suggests nearly 60% odds of a 50 bp move at the next meeting October 4
China officials continue to lean against yuan weakness. The bank set today’s fix at the strong side of market expectations by 647 pips, the most ever. The fix of 6.9396 came despite both CNY and CNH trading well above the 7 level. This comes just days after a senior SAFE official Wang warned that companies should refrain from speculative trading and adhere to a “risk neutral” stance in managing FX risks to cope with external shocks. Yet with monetary policy divergences growing, the yuan is only going to get weaker and so policymakers can only hope to slow the move, not reverse it. USD/CNY and USD/CNH are on track to test the 7.1775 and 7.1965 highs from May 2020, respectively.