Dollar Firm as Risk Off Impulses Pick Up Ahead of the FOMC Decision

September 21, 2022

Win Thin

U.S. yields continue to march higher; Fed tightening expectations remain elevated ahead of the FOMC decision this afternoon; updated macro forecasts and Dot Plots will be released; Canada reported soft August CPI data; Brazil is expected to keep rates steady at 13.75%
Ukraine is heating up again; ECB President Lagarde spoke yesterday; the U.K. announced details of its plan to support businesses hurt by high energy costs; the BOE decision tomorrow is not so clear cut; South Africa reported August CPI
The market is testing the BOJ ahead of tomorrow’s decision; it is likely to deliver another dovish hold; Korea reported trade data for the first 20 days of September

The dollar remains firm as risk off impulses pick up ahead of FOMC decision. DXY is up for the second straight day and traded at a new cycle high near 110.869. If the Fed delivers a hawkish message as we expect (see below), further gains are likely. The euro remains heavy as Ukraine tensions pick up (see below) and is trading near $0.9900. With the fundamentals deteriorating, we look for the euro to soon break below this month’s cycle low near $0.9865 and maintain our medium-term target at the June 2002 low near $0.9305. Sterling also remains heavy and traded at a new cycle low near $1.1305, the lowest since 1985. Charts point to a test of the February 1985 all-time low near $1.0520. Lastly, USD/JPY is creeping higher to trade above 144 for the first time since September 14. If the BOJ meeting ends with a dovish hold tomorrow as we expect (see below), yen weakness should resume in force and the pair should move above 145. The repricing of Fed tightening risks is likely to keep the dollar bid across the board near-term. With Ukraine tensions likely to persist, the global backdrop continues to favor the dollar and U.S. assets in general.

AMERICAS

U.S. yields continue to march higher. The 2-year yield traded near 3.99% yesterday, the highest since October 2007, while the 10-year yield traded near 3.60%, the highest since April 2011. The real 10-year yield traded near 1.17%, the highest since May 2010. This generalized increase in U.S. yields was interrupted today by risk off impulses from Ukraine but this should eventually resume and continue supporting the dollar. Of note, the 3-month to 10-year curve remains positively sloped near 30 bp and so we are not yet ready to call for a recession in the U.S.

Fed tightening expectations remain elevated ahead of the FOMC decision this afternoon. WIRP suggests nearly 20% odds of a 100 bp hike. 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. Powell’s press conference today 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.

Updated macro forecasts and Dot Plots will be released. In light of recent data trends, the growth forecasts will likely be tweaked slightly lower while the inflation forecasts will likely be tweaked slightly higher. Most importantly, 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. Of note, 2025 will be added to the forecast horizon for the first time and could add some nuance to the Fed’s expected rate path.

Existing home sales will be reported and are expected at -2.3% m/m vs. -5.9% in July. Yesterday, August building permits and housing starts were reported. Permits came in at -10.0% m/m vs. -4.8% expected while starts came in at 12.2% m/m vs. 0.3% expected. Data were a mixed bag here but with housing demand slowing sharply, we think the starts number is a big outlier that will eventually join permits lower.

Canada reported soft August CPI data. Headline came in at 7.0% y/y vs. 7.3% expected and 7.6% in July, while core common came in at 5.7% y/y vs. 5.6% expected and a revised 6.0% (was 5.5%) in July. Headline decelerated for the second straight month to the lowest since April vs. the 8.1% peak in June. After the soft August jobs data and the less hawkish tone from the BOC, markets have been adjusting tightening expectations and this CPI simply adds to those impulses. WIRP suggests a 50 bp hike is still fully priced in for October 26 but the swaps market is now pricing in 75 bp of tightening over the next 6 months that would see the policy rate peak near 4.0%, down from 4.0-4.25% at the start of this week and 4.5% earlier this month. New macro forecasts will be released next month’s meeting and will be crucial for forward guidance.

Brazil COPOM is expected to keep rates steady at 13.75%. August IPCA inflation came in at 8.73% y/y vs. 10.07% in July, the lowest since June 2021 but still above the 2-5% target range. COPOM hiked rates 50 bp to 13.75% at the last policy meeting August 3 and said “The Committee will evaluate the need for a residual adjustment, of lower magnitude, in its next meeting. The COPOM emphasizes that it will remain vigilant and that future policy steps could be adjusted to ensure the convergence of inflation towards its targets.” With inflation falling rapidly, it appears that the tightening cycle is nearing an end. However, the swaps market is pricing in small odds of one final hike to 14.0% over the next 3 months.

EUROPE/MIDDLE EAST/AFRICA

Ukraine is heating up again. Russian President Putin announced a partial mobilization of troops, calling up 300,000 reservists in a major escalation of the war in Ukraine. He said “When the territorial integrity of our country is threatened, we will certainly use all the means at our disposal to protect Russia and our people. This is not a bluff.” This comes just after the announcement yesterday that the Russian-held areas of Donetsk and Luhansk will vote on joining Russia in the coming days. Ukraine and the West will not recognize these votes and so tensions are likely to remain high with no diplomatic solution in sight. Deputy Head of the Security Council Medvedev said the votes would be “irreversible” and will allow Russia to use “all possible force in self-defense” of the newly-acquired areas. Thus, the fighting could easily become more widespread if Ukraine makes any effort to retake these regions. Growing risk off impulses suggest markets had become much too complacent about Ukraine in recent weeks.

ECB President Lagarde spoke yesterday. She noted that the bank has front-loaded its rate hikes and added that it expects to hike rates further over the next meetings. However, she added that the eurozone isn’t seeing demand-led price pressures like the U.S. is and that the risks of a wage-price spiral remain contained so far. The ECB will decide rate on a meeting by meeting basis and that the inflation outlook will determine when the tightening cycle ends. These comments nothing out of the ordinary. We hesitate to call her stance as dovish but Lagarde is certainly not as hawkish as Powell has been of late. WIRP suggests 75% 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 U.K. announced details of its plan to support businesses hurt by high energy costs. The proposed GBP40 bln ($45 bln) plan will see the government cap wholesale energy prices for six months. After that initial period, there will be a review to determine whether ongoing support is needed for specific sectors. Of note, this is separate from the GBP130 bln plan to help households cope with higher energy bills. Prime Minister Truss said “There’s a very real danger, before we put in place our business scheme, that cafes, pubs and shops could go out of business, and we simply couldn’t allow that to happen. That’s why it is right for the government to take the steps that we’ve taken.” In related news, the U.K. reported August public sector net borrowing. Ex-banking groups came in at GBP11.8 bln vs. GBP8.0 bln expected and a revised GBP2.9 bln (was GBP4.9 bln) in July. These numbers will only get worse as the government absorbs the higher cost of energy under its plans. CBI also releases the results of its September industrial trends survey. Orders came in at -2 vs. -13 expected and -7 in August, while selling prices came in at 59 vs. 52 expected and 57 in August. Its distributive trades survey will be reported Friday.

The Bank of England decision tomorrow is not so clear cut. The analyst community sees a 50 bp hike by an overwhelming majority. However, WIRP suggests a 75 bp hike is nearly 65% priced in, down from nearly 85% at the start of last week. We favor a 75 bp move. Looking ahead, the swaps market is pricing in 300 bp of tightening over the next 12 months that would see the policy rate peak near 4.75%, up from 4.5% at the start of last week. Last week’s BOE testimony before Parliament was decidedly tepid and so markets will be looking for a much stronger statement of intent tomorrow from Governor Bailey and his colleagues on the MPC. Updated forecasts were just released at the August 4 meeting and so the next update comes November 3.

South Africa reported August CPI. Headline came in as expected at 7.6% y/y vs. 7.8% in July, while core came in two ticks lower than expected at 4.4% y/y. Headline decelerated for the first time since January but still far above the 3-6% target range. SARB meets tomorrow and is expected to hike rates 75 bp to 6.25%. At the last meeting July 21, the bank delivered a hawkish surprise and hiked rates 75 bp to 5.5% vs. 50 bp expected. The vote was 3-1-1, with one dissent in favor of a 50 bp hike and one in favor of a 100 bp hike. Its model saw the policy rate at 5.61% by year-end vs. 5.3% previously, at 6.45% by end-2023 vs. 6.21% previously, and at 6.78% by end-2024 vs. 6.74% previously. This is less hawkish than the market and we expect an upward adjustment to the rate path tomorrow that moves closer to the swaps market, which is pricing in a peak policy rate near 8.0% over the next 12 months.

ASIA

The market is testing the Bank of Japan ahead of tomorrow’s decision. With the 10-year yield testing the 0.25% upper limit of YCC, the bank announced an unscheduled bond buying operation today. The BOJ said it would buy JPY150 bln ($1.04 bln) of 5- to 10-year debt and JPY100 bln of 10- to 25-year debt. This was in addition to the bank’s daily offer to purchase an unlimited quantity of 10-year bonds at 0.25%. When the dust settled, it turns out that the BOJ spent JPY1.26 trln ($8.8 bln) today, the most since June. With the BOJ doing all the buying, there have been no market-based trades reported in the benchmark 10-year for two straight days, the first time this has happened since 1999. We do not think the BOJ will capitulate right now. If it were to do so, yields would jump significantly along with the yen and would jeopardize the nascent economic recovery.

The Bank of Japan is likely to deliver another dovish hold. Governor Kuroda may have to acknowledge upside risks to the FY22 core inflation forecast whilst stressing that it is likely to return back below the 2% target in FY23. At the last meeting July 20-21, the bank delivered a dovish hold. Governor Kuroda emphasized that “We have no intention at all of raising rates under the yield curve control framework. We also have zero intention of expanding the 0.25% range on either side of the yield target. Right now, we need to continue to tenaciously pursue monetary easing.” A policymaker can’t get any more explicit than that and we maintain our view that current policy settings will be maintained through the end of his term in April. Kuroda also touched on the exchange rate, noting that “If you were serious about stopping the weaker yen just with rate increases, you would need significant hikes and they would be very damaging to the economy.” Of note, the macro forecasts were updated modestly in July but did not signal a shift anytime soon from its current ultra-dovish stance. Next forecast update will come at the October 28 meeting.

Korea reported trade data for the first 20 days of September. Exports fell -8.7% y/y and imports rose 6.1% y/y. By adjusting for the number of working days, average daily exports rose 1.8% y/y but still continue the weakening trend. Exports to China came in at -14% y/y, while exports to the U.S. came in at -1.1% y/y. The slowdown in mainland China has had a direct impact on regional activity and trade, with Korea getting hit hard. Recent yen weakness has also hurt Korea’s competitiveness, with the JPY/KRW cross remaining below the key 10 level. That said, we do not think Korean policymakers want to encourage further won weakness as it would feed into already high inflation of 5.7% y/y in August, well above the 2% target. The swaps market is pricing in 125 bp of tightening over the next 12 months that would see the policy rate peak near 3.75%. Next policy meeting is October 12 and another 25 bp hike to 2.75% is expected. Of note, Taiwan reported August export orders at 2.0% y/y vs. 1.1% expected and -1.9% in July.

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