Dollar Firm as U.S. Rates Edge Higher

October 25, 2021

U.S. yields are creeping higher; the Fed is ready to taper; regional Fed manufacturing surveys for October will continue to roll out
Germany reported weak October IFO business climate survey; Bundesbank warned in its monthly report that growth will likely slow in Q4; U.K. breakeven inflation rates continue to climb even as BOE tightening expectations remain elevated; Tensions with the West are rising for Turkey
Recent developments spell trouble for Prime Minister Kishida and his ruling LDP

The dollar is firmer as U.S. rates edge higher. DXY is trading around 93.75 as the week starts off, right in the middle of the 93.50-94.00 range that has largely held in recent days. USD/JPY feels heavy but is finding some support near 113.50. Elsewhere, the euro is also trading heavy and testing support that held last week near $1.1620, while sterling continues to trade below $1.38 area after meeting stiff resistance near $1.3835 all last week. With U.S. data remaining firm, the Fed is ready to taper and markets are fully pricing in Q3 22 Fed liftoff. As such, we believe the move higher in U.S. rates and the dollar will eventually pick up steam again.

AMERICAS

U.S. yields are creeping higher. The 10-year yield is trading around 1.66%, up 3 bp on the day and just below last week’s peak near 1.70%, while the 2-year yield is trading around 0.46%, just below last week’s peak near 0.48%. It’s worth noting that U.S. inflation breakeven rates have come down a bit, with the 5-year now at 2.90% after touching 3.0% last week. The 10-year breakeven rate has also fallen, now at 2.64% after touching 2.70% last week. Fed lift-off is now fully priced in for Q3 22, with a second hike fully priced in for Q4 22. U.S. economic data remain firm and so we believe the upward trajectory in rates and the dollar remains intact.

The Fed is ready to taper. At midnight last Friday, the media embargo went into effect and there will be no Fed speakers until Chair Powell’s press conference the afternoon of November 3. If last week’s Fed speakers are any indication, the Fed is ready and willing to announce tapering at the upcoming FOMC meeting. Indeed, Powell himself said Friday that “The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation.” He added that “I would say our policy is well-positioned to manage a range of plausible outcomes. I do think it’s time to taper and I don’t think it’s time to raise rates.”

Regional Fed manufacturing surveys for October will continue to roll out. Dallas reports today and is expected at 6.2 vs. 4.6 in September. Richmond reports tomorrow and is expected at 5 vs. -3 in September, while Kansas City reports Thursday and is expected at 19 vs. 22 in September. So far, Empire survey came in at 19.8 vs. 34.3 in September and Philly Fed survey came in at 23.8 vs. 30.7 in September. Most of these readings have been at historically high levels and so some moderation is to be expected. September Chicago Fed National Activity Index will also be reported and is expected at 0.20 vs. 0.29 in August.

EUROPE/MIDDLE EAST/AFRICA

Germany reported weak October IFO business climate survey. Headline came in at 97.7 vs. 98.0 expected and a revised 98.9 (was 98.8) in September, with the current assessment falling three ticks to 100.1 and expectations falling two full points to 95.4. German GfK November consumer confidence will be reported Wednesday and is expected at -0.5 vs. 0.3 in October. German data have softened noticeably in recent weeks, which is worrisome for the eurozone as a whole.
The Bundesbank warned in its monthly report that growth will likely slow in Q4. It noted fading momentum in the services sector as well as continued supply bottlenecks in the manufacturing sector would hamper the recovery. The bank said that 2021 GDP growth will be “significantly” lower than its 3.7% forecast from June. Meanwhile, reports suggest that the process to choose a replacement for outgoing Bundesbank President Weidmann are likely to take longer than expected due to protracted coalition talks.

U.K. breakeven inflation rates continue to climb. The 10-year breakeven is trading at 4.21% currently, up 3 bp on the day and just below the 4.25% peak from last week. Looking further out, it is up 42 bp on the month and 121 bp on the year. This seems to be telling us that the market believes that the BOE is falling behind the curve in terms of fighting inflation, and yet most analysts would probably agree with us that a rate hike now is a mistake.

BOE tightening expectations remain elevated. Q4 liftoff is fully priced in, along with four more hikes over the course of 2022. This strikes us as too aggressive, especially with Chancellor Sunak expected to deliver fiscal tightening in his budget speech Wednesday. The 2-year gilt yield is trading around 0.66%, down from the 0.75% peak last week, while the 10-year yield is trading around 1.16%, down from the 1.2% peak last week.

Tensions with the West are rising for Turkey. President Erdogan said over the weekend that ambassadors from ten nations (including the U.S., Germany, and France) were no longer welcome in Turkey. This led USD/TRY to gap higher to trade at a new record high near 9.85 today, though the pair has since drifted lower. The lira is likely to continue suffering from a toxic mix of political tension, rising inflation, and monetary policy mistakes. After two surprise cuts of 100 bp and 200 bp, the central bank is clearly signaling that growth takes precedence over inflation and the exchange rate. Next policy meeting is November 18 and another rate cut is likely then even though inflation is set to accelerate from the plunging lira and rising energy prices.

ASIA

Recent developments spell trouble for Prime Minister Kishida and his ruling Liberal Democratic Party. The latest FNN poll suggests the LDP will win less than 233 of the 465 seats in the lower house, though it would likely maintain a majority with the support of junior coalition partner Komeito. Still, it would be a huge loss for the LDP, which held 276 seats before the Diet was dissolved ahead of the October 31 general election. The same polls found that the main opposition Constitutional Democratic Party could increase its presence by as many as 30 seats. The CDP along with its coalition partners held 112 seats before the Diet was dissolved. Elsewhere, the LDP suffered another blow over the weekend, as it lost a special election for the upper house in Shizuoka. Many political analysts believe a significant loss of seats would see Kishida step down as LDP leader.

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