Dollar Firm as Fed Tightening Expectations Rise

August 31, 2022

Win Thin

Fed officials continue their aggressive communication efforts; the Fed’s hawkish message is clearly having an impact; ADP is restarting its private sector jobs estimates after a two-month hiatus to retool its model; August Chicago PMI is expected to remain steady at 52.1; Canada reports June and Q2 GDP; Banco de Mexico releases its quarterly inflation report
The European energy crisis continues; August eurozone CPI data came in hot; odds of a 75 bp hike at the September 8 ECB meeting continue to rise; Norges Bank will significantly increase its foreign currency purchases in September
Japan reported July IP, retail sales, housing starts, and August consumer confidence; China reported official August PMI readings

The dollar rally has resumed as Fed tightening expectations continue to rise. DXY is trading back above 109 and should soon test the 109.478 cycle high from earlier this week. The euro continues to struggle above parity and is trading heavy near $0.9980. We believe the single currency remains on track to test the September 2002 low near $0.9615. Sterling traded at a new low for this move today near $1.1615 and remains on track to test the March 2020 low near $1.1410. USD/JPY is running into some resistance near 139 but we still look for a test of the July 14 high near 139.40 and maintain our medium-term target of 147.65, the August 1998 high. We maintain our strong dollar call as markets are finally starting to price in the Fed’s hawkish message (see below).

AMERICAS

Fed officials continue their aggressive communication efforts. Yesterday, Bostic said inflation is too high and that policy needs to be restrictive. However, he sees risks to both moving too aggressively and too timidly, adding that the Fed will continue to move expeditiously but carefully. Bostic said it was much too early to declare victory in the inflation fight but acknowledged that the Fed could dial back its 75 bp hikes if prices are clearly cooling. Elsewhere, Williams said the Fed needs somewhat restrictive policy but it’s not there yet. He said “We’re going to need to have restrictive policy for some time. This is not something that we’re going to do for a very short period of time and then change course,” adding that this “will continue through next year.” He said the September decision hinges on the “totality” of the data, echoing Powell’s term. Lastly, Williams said financial conditions reflect Fed policy and that there will come a time when Fed rate actions change.

The Fed’s hawkish message is clearly having an impact. WIRP suggests nearly 75% odds of a 75 bp hike at the September 20-21 FOMC meeting. Looking ahead, the swaps market is now pricing in a 4.0% terminal rate vs. 3.75% at the start of this week. The U.S. 2-year yield traded at a new cycle high near 3.5% yesterday, while the10-year yield traded near 3.16% today, the highest since the end of June. Mester and Bostic speak while the Dallas Fed introduces Logan as its new President. All are expected to maintain the Fed’s hawkish focus on lowering inflation.

ADP is restarting its private sector jobs estimates after a two-month hiatus to retool its model. It is expected at 300k but given the new methodology, it’s anybody’s guess right now whether it’s become more accurate in predicting NFP. Of course, this still sets the table for the jobs data Friday, where consensus sees 300k jobs added vs. 528k in July, while the unemployment rate is expected to remain steady at 3.5% and average hourly earnings are expected to pick up a tick to 5.3% y/y. Of note, yesterday’s July JOLTS data came in strong, with job opening at 11.239 mln vs. 10.375 mln expected and a revised 11.04 mln (was 10.698 mln) in June. While the labor market remains strong, there is no question that unemployment will eventually rise as the Fed continues tightening. However, keep in mind that the labor market is a lagging indicator.

August Chicago PMI is expected to remain steady at 52.1. The Fed manufacturing surveys were mixed and so offer very little insight to the other key surveys. August ISM manufacturing PMI will be reported tomorrow and is expected at 51.9 vs. 52.8 in July. Keep an eye on prices paid and employment, which stood at 60.0 and 49.9 in July, respectively. ISM services PMI won’t be reported until September 6 and consensus sees 55.4 vs. 56.7 in July, the highest since April.

Consumer confidence is recovering. Yesterday, headline August Conference Board reading came in at 103.2 vs. 98.0 expected and a revised 95.3 (was 95.7) in July. This was the highest since May and was driven largely by the 10 point jump in expectations to 75.1, which is noteworthy. The job market remains strong and consumer confidence is improving as gas prices continue to fall. The average gasoline price here has fallen every day since the June 13 peak near $5.016 to $3.844 currently. This is the lowest since March 3 and is approaching pre-Ukraine invasion levels.

Canada reports June and Q2 GDP. Growth is expected at 4.9% y/y and 4.4% SAAR , respectively. The economy remains strong and price pressures remain high and so it’s full speed ahead for the Bank of Canada. WIRP suggests a 75 bp hike is fully priced in for September 7, with very low odds of a 100 bp move. The swaps market is pricing in 150 bp of tightening over the next 6 months that would see the policy rate peak near 4.0%.

Banco de Mexico releases its quarterly inflation report. Minutes from the August meeting were very hawkish, with members noting that extra rate hikes will be needed and that inflation expectations are starting to de-anchor. Members noted that core inflation is showing “significant persistence” and the upward trend is “concerning.” With regards to growth, members noted private consumption has started to slow and that the recovery will continue at a slower pace than H1. Bottom line: the inflation report is likely to contain higher inflation forecasts, lower growth forecasts, and bias towards further tightening. Next policy meeting is September 29 and another 75 bp hike to 9.25% seems likely. The swaps market is pricing in 175 bp of tightening over the next 6 months that would see the policy rate peak near 10.25%, up from 9.75% at the start of last week.

EUROPE/MIDDLE EAST/AFRICA

The European energy crisis continues. Russia’s Gazprom said it will halt all natural gas shipments to French utility Engie SA because of a disagreement over payments. Gazprom said it has notified Engie of a full cutoff of gas supplies beginning September 1 because it hasn’t paid in full for its July deliveries. Engie official said that with France’s gas storage over 90% full, the nation should be able to cope with an average winter but warned of trouble from potential cold snaps. In addition, Gazprom said it plans to shut the Nord Stream pipeline to Germany for three days of maintenance starting today. That pipeline had been running at around 20% of capacity but Germany has still been able to increase its gas storage and will likely meet its 85% target next month. European Commission President von der Leyen said that gas reserves in the EU have hit an average of 80%, a target that was set for November 1.

August eurozone CPI data came in hot. Headline rose 9.1% y/y vs. 9.0% expected and 8.9% in July, while core came in at 4.3% y/y vs. 4.1% expected and 4.0% in July. Both are at new record highs. Of note, France came in at 6.5% y/y vs. 6.7% expected and 6.8% in July, while Italy came in at 9.0% y/y vs. 8.2% expected and 8.4% in July. Yesterday, Germany came in as expected at 8.8% y/y vs. 8.5% in July, while Spain came in as expected at 10.3% y/y vs. 10.7% in July.

Odds of a 75 bp hike at the September 8 ECB meeting continue to rise. WIRP suggests nearly 75% odds of a 75 bp move vs. 50% at the start of the week. Looking ahead, the swaps market is now pricing in 250 bp of tightening over the next 12 months that would see the deposit rate peak near 2.5%, up from 2.0% at the start of last week. The problem with large-scale ECB hikes (the same goes for the BOE) is that they are hiking into a recession that's pretty much already here. Germany, Italy, and now France are contracting and it's only going to get worse this fall/winter when energy shortages really bite. Of note, Germany reported August unemployment at 28k vs. a revised 45k (was 48k) in July, which led the unemployment rate to rise a tick to 5.5%. Elsewhere, France reported July consumer spending at -0.8% m/m vs. -0.2% expected and a revised 0.1% (was 0.2%) in June, while the y/y rate was -4.3% vs. -3.9% expected.

Norges Bank will significantly increase its foreign currency purchases in September. The bank will purchase NOK3.5 bln ($350 mln) per day in September vs. NOK1.5 bln in August. The government receives revenue in both krone and foreign currency. The proceeds will fund the budget deficit and whatever isn’t spent is funneled as foreign currency into Norway’s $1.2 trln sovereign wealth fund. Norges Bank conducts these FX trades on the government’s behalf. The increased amount was unexpected and has led NOK to be the worst performing major today. A weaker currency complicates Norges Bank’s task of lowering inflation. It just hiked rates 50 bp to 1.75% this month and noted the policy rate “will most likely be raised further in September” without indicating the likely size. We look for another 50 bp hike to 2.25% September 22. Of note, 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%.

ASIA

Japan reported July IP, retail sales, housing starts, and August consumer confidence. IP came in at 1.0% m/m vs. -0.5% expected and 9.2% in June, while the y/y rate came in at -1.8% vs. -2.4% expected and -2.8% in June. Sales came in at 0.8% m/m vs. 0.3% expected and -1.3% in June, while the y/y rate came in at 2.4% vs. 1.9% expected and 1.5% in June. Housing starts came in at -5.4% y/y vs. -3.5% expected and -2.2% in June, while confidence came in at 32.5 vs. 29.5 expected and 30.2 in July. While the PMI readings have weakened significantly in Q3, the real sector data have remained fairly firm. For now, we believe the Bank of Japan will maintain its ultra-loose policy. Next policy meeting is September 21-22 and no change is expected then.

China reported official August PMI readings. Manufacturing came in at 49.4 vs. 49.2 expected and 49.0 in July while non-manufacturing came in at 52.6 vs. 52.3 expected and 53.8 in July. As a result, the composite PMI fell to 51.7 vs. 52.5 in July. Caixin reports its August manufacturing PMI tomorrow and is expected at 50.0 vs. 50.4 in July, followed by its services PMI Monday that is expected at 54.0 vs. 55.5 in July. The economy is clearly slowing much faster than policymakers expected, which explains the CNY1 trln stimulus package announced last week as well as other policy measures. Despite recent stimulus, we believe the economy will continue slowing and that will have spillover effects to the rest of the region.

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