Dollar Firm as U.S. Returns From Holiday

September 06, 2022
  • Last week’s data show the U.S. economy remains on firm footing; data highlight will be August ISM services PMI; Chile is expected to hike rates 75 bp to 10.5%
  • ECB officials are starting to recognize the risks ahead; Germany reported weak July factory orders; the Tories picked Foreign Secretary Truss as their new leader, as expected; reports suggest Truss is focusing on providing relief from surging energy prices; sterling is seeing a bounce on these reports but we would fade it
  • Japan reported soft July cash earnings and household spending; RBA hiked rates 50 bp to 2.35%, as expected; PBOC is taking modest measures to support the yuan; OPEC+ surprised markets with a 100k bbl/day output cut in October

The dollar remains bid as the U.S. returns from holiday. After trading at a new cycle high yesterday near 110.271, DXY is trading near 109.815. The euro continues to struggle and traded at a new cycle low near $0.9880 yesterday before recovering to $0.9930 currently. We believe it remains on track to test the September 2002 low near $0.9615. Sterling also traded at a new low for this move yesterday near $1.1445 but recovered to trade back above $1.16 on news of Truss’ plans to provide energy price relief to households and firms (see below). We would fade this bounce as sterling remains on track to test the March 2020 low near $1.1410. After that is the December 1985 all-time low near $1.0520. USD/JPY traded at a new high for this move near 141.85 today and we maintain our medium-term target of 147.65, the August 1998 high. Indeed, we maintain our strong dollar call as it benefits from both a solid U.S. economic outlook and growing risk-off impulses from Europe.

AMERICAS

Last week’s data show the U.S. economy remains on firm footing. The jobs report was solid, as were Chicago and ISM manufacturing PMI readings. After a weak Q2 reading of -0.6% SAAR, GDP growth has picked up and the Atlanta Fed’s GDPNow model is currently tracking 2.6% SAAR for Q3. What this means is that the Fed is on track to continue hiking rates aggressively. In turn, this supports our ongoing strong dollar call.

Data highlight will be August ISM services PMI. Headline is expected at 55.4 vs. 56.7 in July. Keep an eye on employment and prices paid, which stood at 49.1 and 72.3 in July, respectively. ISM manufacturing PMI came in strong than expected, but we note that S&P Global readings have come in on the weak side of ISM in recent months.

Chile central bank is expected to hike rates 75 bp to 10.5%. However, nearly half the analysts polled by Bloomberg see a smaller 50 bp move. At the last meeting July 13, the bank delivered a hawkish surprise with a 75 bp hike to 9.75% vs. 50 bp expected. The vote was unanimous and the bank said more hikes will be needed while removing a reference in the previous statement about reducing the size of future moves. The bank releases its quarterly monetary policy tomorrow, while August CPI will be reported Thursday with headline expected at 13.8% y/y vs. 13.1% in July. If so, it would be the highest November 1992 and further above the 2-4% target range. The swaps market is pricing in 125 bp of tightening over the next 3 months that would see the policy rate peak near 11.0%.

EUROPE/MIDDLE EAST/AFRICA

European Central Bank officials are starting to recognize the risks ahead. Noted hawk Kazaks said “The risks of a broad-based and protracted recession with a reductive impact on inflation would point towards a slower pace of rate hikes or a pause.” However, he noted that “The persistence of core inflation and its impact on inflation expectations along with wage dynamics will be key to determine whether a steady pace of interest-rate hikes should be maintained.” Lastly, Kazaks said the ECB won’t hesitate to lift rates above the neutral rate.

The ECB meets Thursday and is expected to hike rates 75 bp. However, nearly half the analysts polled by Bloomberg look for smaller cuts of either 25 or 50 bp. WIRP suggests slightly less than 50% odds of a 75 bp hike and so it will be a very close call. Higher than expected August CPI readings support the case for more aggressive tightening. While the deepening energy crisis adds another wrinkle to the process, we think it is too early to impact ECB policy right now.

Final August eurozone services and composite PMIs were reported yesterday. The composite fell to 48.9 vs. 49.2 preliminary, driven largely by a drop in the services PMI to 49.8 vs. 50.2 preliminary. Looking at the country readings, the German composite fell to 46.9 vs. 47.6 preliminary, while the French composite rose to 50.4 vs. 49.8 preliminary. Italy and Spain report for the first time and their composite PMIs came in at 49.6 and 50.5, respectively. We believe France’s improvement was a quirk, while Spain is likely to follow the other large eurozone economies into contractionary territory in September. July eurozone retail sales were also reported yesterday and came in a tick weaker than expected at 0.3% m/m vs. a revised -1.0% (was -1.2%) in June.

Germany reported weak July factory orders. Orders came in at -1.1% m/m vs. -0.7% expected and a revised -0.3% (was -0.4%) in June, while the y/y rate came in at -13.6% vs. -9.0% in June. IP will be reported tomorrow and is expected at -0.6% m/m vs. 0.4% in June, while the y/y rate is expected at -2.1% vs. -0.5% in June.

The Tories picked Foreign Secretary Truss as their new leader, as expected. However, the margin of 57-43% over former Chancellor Sunak was much closer than opinion polls suggested. Truss inherits an awful economic backdrop and there are clear risks that she makes things even worse.

Reports suggest Truss is focusing on providing relief from surging energy prices. The incoming government has reportedly drafted plans to cap annual energy bills for U.K. households at or below the current level of GBP1,971 ($2,300). This would prevent the huge increase that’s due to kick in at the start of October. The policy could cost as much as GBP130 bln over the next 18 months. Relief is likely to be extended to U.K. firms with a planned GBP40 bln ($46 billion) support package to lower energy bills for businesses. Here, policymakers are reportedly looking at two options; one is to cap energy costs for firms in a similar manner to the household cap, while the other is a price reduction that all energy suppliers must offer U.K. companies. The government would reimburse energy suppliers for any losses while the prices charged to businesses would be reviewed quarterly.

Sterling is seeing a bounce on these reports but we would fade it. While any relief from higher energy prices would be welcome, the huge costs to the government are totally inconsistent with Truss’ pledge to cut taxes immediately. With recession coming, we believe the fiscal outlook remains poor even as borrowing costs for the Treasury are rising. In that regard, final U.K. August services and composite PMIs were reported yesterday. The composite fell to 49.6 vs. 50.9 preliminary, driven largely by a drop in the services PMI to 50.9 vs. 52.5 preliminary. The composite reading is below 50 for the first time since February 2021 and confirms what we all knew already: the U.K. economy is taking the first small steps into recession.

ASIA

Japan reported soft July cash earnings and household spending. Nominal earnings came in a tick lower than expected at 1.8% y/y vs. 2.0% in June, while real earnings came in a tick lower than expected at -1.3% y/y vs. -0.6% in June. Elsewhere, spending came in at 3.4% y/y vs. 4.6% expected and 3.5% in June. BOJ officials have been focusing on the need to see significant wage gains along with getting inflation sustainably at the 2% target in order to consider liftoff. With wages still depressed, the bank will feel vindicated in its decision to maintain ultra-loose policy for the foreseeable future. Next BOJ meeting is September 21-22 and no change is expected then.

Reserve Bank of Australia hiked rates 50 bp to 2.35%, as expected. It said that “The Board is committed to returning inflation to the 2–3% range over time. It is seeking to do this while keeping the economy on an even keel. The path to achieving this balance is a narrow one and clouded in uncertainty, not least because of global developments.” Similar to the last meeting, the bank said “The Board expects to increase interest rates further over the months ahead, but it is not on a pre-set path. The size and timing of future interest rate increases will be guided by the incoming data and the Board’s assessment of the outlook for inflation and the labor market.” Lowe speaks on Thursday and is likely to provide more clues to future policy. WIRP suggests only 20% odds of a 50 bp move at the next meeting October 4, while the swaps market is pricing in 200 bp of tightening over the next 12 months that would see the policy rate peak near 4.35%. Since updated macro forecasts were just released at the August 2 meeting, we won’t see the next update until the November 1 meeting.

People’s Bank of China is taking modest measures to support the yuan. Yesterday, it reduced the amount of FX deposits that banks need to set aside as reserves for the second time this year, to 6% from 8% previously. The move would ostensibly free up foreign exchange to meet increased demand but it is by no means a game-changer. Recent yuan fixes have also been firmer than expected. Officials have been jawboning and taking modest measures to support the yuan but this should only be seen as leaning against the wind. With start monetary policy divergence in play here, the fundamentals argue for a weaker yuan as interest rate differentials continue to move in the dollar’s favor.

COMMODITIES

OPEC+ surprised markets with a 100k bbl/day output cut in October. This reverses the 100k increase in September that was seen as a response to requests by President Biden to boost output. However, there were some hints of a cut after Saudi officials recently warned of the negative impact of excessive volatility in oil markets. However, cutting output to raise prices as the world slides into recession is a very risky move. The group stressed that it could call another at any time if needed to address market developments ahead of its next scheduled meeting October 5.

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