Dollar Firms Ahead of FOMC

July 27, 2021

U.S. 10-year real yields fell to a new record low of -1.14%; two-day FOMC meeting begins today and ends with a decision tomorrow; market expectations for Fed policy are worth mentioning; Fed manufacturing surveys for July will continue to roll out
Eurozone M3 data for June was reported; details of the ECB asset purchases for the week ending July 23 will be reported; UK CBI reported the results of its July distributive trades survey; Hungary is expected to hike the base rate 20 bp to 1.10%
U.S.-China talks ended with little to show; China’s industrial profits slowed down considerably in June to 20.0% y/y from 36.4% in May; Korea’s 2Q GDP figures came in a touch below expectations

The equity market divergence between DM and EM, and intra-EM is widening fast. The main driver here is the performance of Chinese stocks, especially tech-related, which we have already covered extensively. Hong Kong’s main index is now down a whopping 8% on the year, and the Shanghai index is down nearly 3%. This has dragged the broader MSCI EM index into negative territory for the year (-1%) even though MSCI Eastern Europe (+13%) and MSCI LatAm indices (+4%) are posting respectable gains. It’s also worth noting the relatively poor performance of LatAm in generally, where negative political developments in every major South American economy has offset what could have been a year of strong commodity-led performance for the region.

The dollar is firm ahead of the FOMC meeting that begins today. DXY has recouped much of yesterday’s losses and is trading just below 93. It should eventually test the March 31 high near 93.437. The euro was unable to mount a credible move above the $1.18 area, while sterling is having trouble making a clean break above $1.38 even though the virus news stream has improved (see below). USD/JPY is trading heavy and is testing the 110 area. A break below 109.65 would set up a test of the July 19 low near 109.05.

AMERICAS

U.S. 10-year real yields fell to a new record low of -1.14%. The drop is coming from both sides, as 10-year breakeven inflation rates rose to 2.40% and nominal yields fell to 1.25%. Nominal yields suggest bond markets are getting increasingly concerned about the potential deflationary impact of the delta variant, but inflation breakevens suggest greater concern about the current inflation outlook. This is a very difficult situation to reconcile and makes the Fed’s messaging even more complicated.

The two-day FOMC meeting begins today and ends with a decision tomorrow. We expect a modestly hawkish hold, as the Fed is likely to acknowledge ongoing inflation risks and that it is continuing with its discussions of tapering. Tapering could be mentioned in the official statement, which would be a very hawkish surprise. There won’t be updated macro forecasts or Dot Plots until the September FOMC meeting. Because this is widely seen as a placeholder meeting, we think markets will be susceptible to surprises at either end of the hawk/dove spectrum. We lean toward a hawkish surprise, in which case the dollar rally should continue. On the other hand, a rise in risk off impulses is possible given the global spread of the delta variant, which would also tend to favor the dollar.

Market expectations for Fed policy are worth mentioning. The latest Bloomberg poll of 51 economists shows most respondents expect tapering in early 2022 and will be weighted more towards MBS. Three quarters expect an early tapering signal either at the August 26-28 Jackson Hole Symposium or the September 21-22 FOMC meeting. Half see a formal announcement at the December 14-15 FOMC meeting, while nearly three quarters see actual tapering starting in Q1 2022. Most expect tapering to last 10-12 months, which would see QE end in early 2023. After that, most respondents see two 25 bp hikes in 2023, followed by three more in 2024 that would take the ceiling for the Fed Funds rate up to 1.5% from 0.25% currently.

This consensus timeline is close to what we have long expected. Much will depend on the data but if we had to weight the risks, it would be that tapering and rate hikes happen sooner than what the market expects, not later. This is because we remain very optimistic about the U.S. economic outlook and continue to see heightened inflation risks ahead. Contrast this to the BOJ and ECB, which over the past two weeks have signaled that rate hikes are unlikely until 2024 at the earliest. There are also growing rumblings that the RBA will reverse its recent decision to taper. This ongoing central bank divergence is central to our strong dollar call for H2.

Fed manufacturing surveys for July will continue to roll out. Richmond Fed is expected at 20 vs. 22 in June. So far, Dallas came in at 27.3 vs. vs. 31.1 in June, Kansas City came in at 30 vs. 27 in June, Empire manufacturing came in at 43.0 vs. 17.4 in June, and Philly Fed came in at 21.9 vs. 30.7 in June. Of note, Markit preliminary July PMI readings were reported last week, with manufacturing coming in at 63.1 vs. 62.0 expected and 62.1 in June and services coming in at 59.8 vs. 64.5 expected 64.6 in June. This dragged the composite PMI down to 59.7 from 63.7 in June. All of these surveys remain at historically high levels and so the manufacturing sector continues to grow robustly. Durable goods orders (2.1% m/m expected) and July Conference Board consumer confidence (124.0 expected) will also be reported today.

EUROPE/MIDDLE EAST/AFRICA

Eurozone M3 data for June was reported. Growth slowed to 8.3% y/y vs. 8.2% expected and a revised 8.5% (was 8.4%) in May. It was the fifth straight month of deceleration and the lowest since May 2020. No wonder the ECB is worried about removing accommodation too soon. The issue of QE was punted to a later meeting. While the September 9 meeting might yield an announcement, we suspect deep differences within the ECB will require more time to resolve. Discussions will be held in the coming months but we believe the December 16 meeting is the one that will yield some sort of extension in QE beyond the March 2022 expiry of PEPP. The existing APP is likely to be modified in order to increase its monthly pace of purchases currently around EUR20 bln.

Details of the ECB asset purchases for the week ending July 23 will be reported. Yesterday, net purchases were reported at EUR22.8 bln vs. EUR22.1 bln in each of the weeks ending July 16 and July 9. Redemptions and gross purchases will be reported today. The ECB has been aiming for net weekly purchases of around EUR20 bln since the accelerated pace began in March, but there have been a couple of outliers on both sides. That said, the large net purchases the past three weeks underscore our belief that the ECB will not risk making any premature moves that could endanger the recovery. Indeed, we expect purchases to remain a bit above average in the coming weeks in order to give the ECB’s recent policy changes more heft.

UK CBI reported the results of its July distributive trades survey. Retailing reported sales fell to 23 vs. 20 expected and 25 in June, while total reported sales rose to 41 from 40 in June. Virus numbers fell for the sixth straight day to 25k, half the recent peak and taking many by surprise. That said, the potential impact of last Monday’s Freedom Day would only be seen in the coming days and so it’s too early to sound the all clear. However, the trend is encouraging and may serve as a beacon of hope for other countries that are grappling with the current spike in infections. Stay tuned.

National Bank of Hungary is expected to hike the base rate 20 bp to 1.10%. However, the market is split. Of the 19 analysts polled by Bloomberg, 9 see a 15 bp hike, 2 see 20 bp hike, and 8 see a 30 bp hike. The bank started a tightening cycle June 22 with a 30 bp hike in the base rate to 0.90%. CPI rose 5.3% y/y in June, the highest since October 2021 and further above the 2-4% target range.

ASIA

U.S.-China talks ended with little to show. Foreign Minister Wang Yi reportedly demanded that the U.S. stop criticizing China’s political system, end all sanctions and tariffs, and stay out of Hong Kong, Taiwan, and Xinjiang affairs. None of those are happening anytime soon and so the slow simmer continues. U.S. officials said they were focused on setting guardrails rather than negotiating specific issues and described the talks as forthright and professional. There is some speculation about a potential summit later this year between Presidents Xi and Biden but nothing has been confirmed so far.

China’s industrial profits slowed down considerably in June to 20.0% y/y from 36.4% in May. The decline is in part due to less favorable base effects, but it also suggests changes in slowing profit in certain sectors as well as lower gate prices (as seen by moderating PPI figures). In general, the mining sector continues to power ahead even as the manufacturing sector decelerates. However, declining profits at a time of rising regulatory risks suggest that mainland stocks are unlikely to turn around anytime soon, especially if foreign investors are further discouraged.

Korea’s 2Q GDP figures came in a touch below expectations. However, it should not derail the view that a rate hike is coming sometime in the next few meetings. GDP rose 0.7% q/q and 5.9% y/y, bot a tick below consensus. Growth came largely from private consumption and government spending, with a less sanguine performance of the external sector. There are already some calls for a hike as early as the August 26 meeting, but we think the BOK will take its time and ensure the resurgence in virus cases gets under control first – only 13% of the population has been fully vaccinated. While a hike this year is warranted, in our view, there is no urgency with CPI near 2.5% y/y. The latest budget stimulus (worth $30 bln) with a strong direct transfer component will boost demand but will take time to filter through. The won has been one of the worst performing currencies in the region this month (-2% vs. USD), but the Kospi has held up well against the negative sentiment coming from the Chinese tech sector.

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