Dollar Firm as the U.S. Returns from Holiday

February 21, 2023

Win Thin

U.S. yields continue to rise; we get some key February survey readings; housing sector data are expected to show continued weakness; Canada highlight will be January CPI data
Eurozone and U.K. reported firm preliminary February PMI readings; Germany reported firm February ZEW readings; U.K. posted a surprise budget surplus in January; Israel delivered a hawkish surprise and hiked rates 50 bp to 4.25% vs. 25 bp expected
The 10-year JGB yield rose above the 0.50% YCC ceiling for the first time since January; Japan and Australia reported preliminary February PMI readings; RBA released hawkish minutes; New Zealand reported Q4 PPI data; Korea reported soft trade data for the first 20 days of February

The dollar is firm as the U.S. returns from holiday. DXY is trading just below 104 and we look for a test of last week’s high near 104.667. Break above that would set up a test of the January 6 high near 105.631. The euro is trading lower near $1.0655 and is on track to test last week’s low near $1.0615. Break below that would set up a test of the January 6 low near $1.0485. Sterling is outperforming after better than expected economic data (see below) and trading back above $1.21. We would fade this bounce and look for cable to revisit last week’s low near $1.1915. Break below that would set up a test of the January 6 low near $1.1840. USD/JPY is trading near 134.60 and is on track to test last week’s high for this move near 135.10. Break above that would set up a test of the December 20 high near 137.50, right before the BOJ shocked markets with its YCC tweak. To state the obvious, the recent U.S. data have come around to support our more hawkish view on the Fed, which in turn supports our call for a stronger dollar. Market sentiment is finally swinging back in the dollar’s favor and we remain hopeful that the data continue to encourage this shift.

AMERICAS

U.S. yields continue to rise. The 2-year yield traded near 4.71% Friday, the highest since November 8 and on track to test the November 4 cycle high near 4.80%. It is trading near 4.67% today. The 10-year yield traded near 3.93% Friday, the highest since November 10 and now on track to test the November 8 high near 4.24%. After that, the next target is the October 21 cycle high near 4.34%. It is trading near 4.88% today. The move higher in yields coincides with renewed inflation concerns and a much-needed repricing of Fed tightening expectations. This process still has a ways to go, in our view.

Fed tightening expectations remain elevated. WIRP suggests 25 bp hikes in March, May, and June that takes Fed Funds to 5.25-5.50%. Given how strong the data have been recently, we see growing risks of a fourth 25 bp hike that takes us up to 5.50-5.75%, though that is not being priced in yet. This should eventually change. Strangely enough, an easing cycle is still expected to begin in Q4 but at much lower odds. Eventually, it should be totally priced out into 2024 in the next stage of Fed repricing.

Yet financial conditions continue to loosen. As of February 10, conditions as measured by the Chicago Fed are the loosest since late February 2022 while its adjusted measure is the loosest since early February 2022. This must be frustrating for the Fed but all it can do is to continue hiking rates and giving hawkish forward guidance. At some point soon, we think conditions will have to tighten as interest rates continue to rise. Credit spreads have also started to widen out this month and so perhaps we are at the beginning of this adjustment process. Now, if only the equity markets would get the message……

We get some key February survey readings. Preliminary S&P Global PMIs will be reported. Manufacturing is expected at 47.4 vs. 46.9 in January, services is expected at 47.3 vs. 46.8 in January, and the composite PMI is expected at 47.5 vs. 46.8 in January. Will these PMIs also come in stronger than expected as the eurozone and U.K. did? Philadelphia non-manufacturing index will also be reported.

Housing sector data are expected to show continued weakness. January existing home sales will be reported and is expected at 2.0% m/m vs. -1.5% in December. New homes sales will be reported Friday and is expected at 0.7% m/m vs. 2.3% in December.

Canada highlight will be January CPI data. Headline is expected at 6.1% y/y vs. 6.3% in December, while core median is expected to fall a tick to 4.9% y/y and core trim is expected to fall a tick to 5.2% y/y. December retail sales data will also be reported. Headline is expected at 0.5% m/m vs. -0.1% in November, while ex-autos is expected at -0.1% m/m vs. -0.6% in November. Bank of Canada expectations have picked up after the second straight blowout jobs report. If data continue to come in firm, the bank will find it harder and harder to justify its pause. No change is expected at the next meeting March 8 but WIRP suggests 50 bp of tightening to 5.0% is nearly priced in over the next 6 months.

EUROPE/MIDDLE EAST/AFRICA

Eurozone reported firm preliminary February PMI readings. Headline manufacturing came in at 48.5 vs. 49.3 expected and 48.8 in January, services came in at 53.0 vs. 51.0 expected and 50.8 in January, and the composite came in at 52.3 vs. 50.7 expected and 50.3 in January. Looking at the country breakdown, the German composite came in at 51.1 vs. 50.3 expected and 49.9 in January and the French composite came in at 51.6 vs. 49.8 expected and 49.1 in January. Italy and Spain will not be reported until the final PMI readings early next month. While many of the survey indicators appear to have bottomed, we warn against getting too excited about the eurozone outlook as the hard data remain weak.

Germany reported firm February ZEW readings. Expectations component came in at 28.1 vs. 23.0 expected and 16.9 in January and the current situation component came in at -45.1 vs. -50.5 vs. -58.6 in January. IFO business climate will be reported tomorrow. Headline is expected at 91.2 vs. 90.2 in January, driven by increases in both current assessment and expectations to 95.0 and 88.2, respectively. March GfK consumer confidence will be reported Friday and is expected at -30.5 vs. -33.9 in February.

ECB tightening expectations have steadied. WIRP suggests a 50 bp hike March 16 is nearly priced in. Looking further ahead, a 25 bp hike May 4 is priced in with around 40% odds of a larger 50 bp move. Another 25 bp hike June 15 is priced in, followed by one last 25 bp hike in Q3 that would result in a peak policy rate near 3.75%. These expectations are likely to drift lower if continued disinflation gives the doves the upper hand again.

U.K. reported firm preliminary February PMI readings. Headline manufacturing came in at 49.2 vs 47.5 expected 47.0 in January, services came in at 53.3 vs. 49.2 expected and 48.7 in January, and the composite came in at 53.0 vs. 49.0 expected and 48.5 in January. CBI also released the results of its February industrial trends survey, with total orders coming in at -16 vs. -15 expected and -17 in January and selling prices at 40 vs. 35 expected and 41 in January. Its distributive trades survey will be reported Thursday. Here too, we cannot get excited about the recent recovery in the sentiment indicators as the hard data remain weak. It’s just not going to be that easy for policymakers in both the U.K. and eurozone.

The U.K. posted a surprise budget surplus in January. Public sector net borrowing ex-banking groups came in at -GBP5.4 bln vs. GBP7.9 bln expected and a revised GBP25.6 bln vs. GBP27.4 bln previously. There is clearly a cyclical element as the government tends to post surpluses in January but markets were braced for a deficit given the awful fiscal outlook. However, Treasury posted a primary surplus of GBP5.4 bln due to strong income tax revenue and also saw lower than anticipated debt servicing costs. Overall, borrowing for FY2022 that ends in March is running GBP22 bln below what the Office for Budget Responsibility forecast back in November and increases to GBP30.6 bln when student loans are excluded. This gives Chancellor Hunt some room to breathe as he prepares the FY2023 budget to be announced in March. That said, it is still very hard to get very excited about the U.K. fundamental outlook right now.

BOE tightening expectations have steadied. WIRP suggests a 25 bp hike March 23 is nearly priced in. After that, a 25 bp hike is nearly priced in for Q2 and very low odds of another hike in Q3 and so the expected terminal rate remains near 4.5%. This is still well below the peak near 6.25% right after the disastrous mini-budget back in September.

Bank of Israel delivered a hawkish surprise and hiked rates 50 bp to 4.25% vs. 25 bp expected. The bank said it had “decided to continue the process of increasing the interest rate” but added that it is unsure how much further it will have to hike and that the April 3 decision will be data dependent. Deputy Governor Abir said that the weak shekel and high inflation were behind the larger hike, adding that the exchange rate will be a factor for setting monetary policy even as political uncertainty is affecting FX and equity markets. Of note, January CPI came in higher than expected at 5.4% y/y and was a new high for this cycle. The swaps market is now pricing in a peak policy rate near 4.75% vs. 4.0% before the decision.

ASIA

The 10-year JGB yield rose above the 0.50% YCC ceiling for the first time since January. It appears some are looking for another tweak to YCC ahead of the parliamentary confirmation hearing Friday for Governor-designate Ueda. Markets are perhaps coming to grips with the fact that accommodation will likely be removed this year no matter who becomes the next BOJ Governor. Yet expected BOJ liftoff is not imminent. Next BOJ policy meeting March 9-10 will be the last one under Governor Kuroda and while no change is expected, we simply cannot rule out one last surprise to help take some heat off of Ueda. WIRP suggests nearly 30% odds of liftoff April 28, rising to nearly 60% June 16 and then nearly priced in for July 28. That said, the actual tightening path is seen as very mild as the market is pricing in 25 bp of tightening over the next 12 months followed by only 30 bp more over the subsequent 24 months. That is why we expect the knee-jerk drop in USD/JPY after liftoff to be fairly limited.

Japan reported preliminary February PMI readings. Manufacturing came in at 47.4 vs. 48.9 in January, services came in at 53.6 vs. 52.3 in January, and the composite PMI was steady at 50.7 after rising two straight months.

Reserve Bank of Australia released hawkish minutes. At that February 7 meeting, the minutes showed that the bank discussed hiking rates either 25 or 50 bp before settling on a 25 bp hike to 3.35%. There was no discussion of a pause, which it did at the December meeting. The minutes also showed that the argument behind a 50 bp move was a “pattern of incoming prices and wages data exceeding expectations, and a risk that high inflation would be persistent.” Clearly, the RBA is nowhere close to pausing. WIRP suggests nearly 80% odds of a 25 bp hike at the next meeting March 7, while the swaps market is pricing in a peak policy rate near 4.30% over the next 12 months followed by an easing cycle over the subsequent 12 months, highlighting the “higher for longer” theme.

Australia also reported preliminary February PMI readings. Manufacturing came in at 50.1 vs. 50.0 in January, services came in at 49.2 vs. 48.6 in January, and the composite PMI came in at 49.2 vs. 48.5 in January. The composite has risen two straight months to the highest since October but remains below the 50 boom/bust level.

New Zealand reported Q4 PPI data. PPI input came in at 8.0% y/y vs. 8.8% in Q3, while PPI output came in at 7.7% y/y vs. 8.4% in Q3. These readings should bode well for CPI going forward, but the recent floods will likely lead to a spike in Q1. The Reserve Bank of New Zealand meets tomorrow and is expected to hike rates 50 bp to 4.75%. WIRP suggests a 50 bp hike is about 80% priced in. Looking ahead, 25 bp hikes are largely priced in for April, May, and June that would see the policy rate peak near 5.5%. However, the market is still pricing the start of an easing cycle in the subsequent 6 months and that seems very unlikely.

Korea reported soft trade data for the first 20 days of February. Exports came in at -2.3% y/y and imports came in at 9.3% y/y. However, adjusting for the number of working days, average daily exports came in at -14.9% y/y. Shipments to China came in at -22.7% y/y while shipments to the U.S. came in at 29.3% y/y. On Monday, Taiwan reported January export orders at -19.3% y/y vs. -24.0% expected and -23.2% in December. So far, there have been no signs of a positive impact on regional trade and activity from China reopening.

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