Dollar Firms Despite Falling U.S. Yields

June 11, 2021
  • The G-7 summit begins today in Cornwall; May CPI data surprised the upside; yet U.S. rates continue to fall; next week’s FOMC meeting is coming into focus; weekly jobless claims data show continued healing of the labor market; Peru left rates on hold at 0.25% last night, as expected
  • ECB delivered a dovish hold, as expected; U.K. data today were decidedly mixed; BOE tightening expectations remain elevated as a result of the strong recovery; U.K. Prime Minister Johnson will reportedly delay the final stage of reopening; Russia hiked rates 50 bp to 5.50%, as expected; recent lira gains have accelerated, possibly related to optimism about the upcoming Biden-Erdogan meeting
  • BOK is joining the fray of central banks that are signaling that tightening is on the way

The dollar is building on its recent gains. DXY is up for the third day out of the past four and is trading back near the week’s highs around 90.20. A clean break above 90.325 is needed to set up a test of last week’s pre-NFP high near 90.627. The euro is trading heavy in the wake of the dovish ECB decision (see below) and a break below $1.2150 would set up a test of the June 4 low near $1.2105. Sterling is trading just below $1.42, while USD/JPY has remained stuck around 109.50 all week after being unable to sustain the break above 110 Friday. That the dollar is gaining despite lower U.S. yields (see below) is noteworthy. We believe the fundamental story favors the dollar and that next week’s FOMC meeting may be key for the next leg up in the greenback.

The G-7 summit begins today in Cornwall. It is the first in-person summit in two years because of the pandemic. Of course, these summits are largely glorified photo ops but this year’s meeting is notable for several reasons. For one, it will be Merkel’s last after serving 16 years as Chancellor. It will be Draghi’s first and even though he is leading a technocratic government, he brings more gravitas than any Italian leader in recent history. It is Suga’s first and it may also be his last if recent polls in Japan prove accurate. It is also Biden’s first as president and he will make strong efforts to repair frayed relations with some of our closest allies. He and Yellen have already secured a deal on the global minimum tax and so that’s a good start. Climate change will reportedly be at the top of the agenda, and we suspect China and Russia will also be discussed.

AMERICAS

May CPI data surprised the upside. Headline inflation rose 5.0% y/y vs. 4.7% expected and 4.2% in April, while core rose 3.8% y/y vs. 3.4% expected and 3.0% in April. For headline, this is the highest since August 2008 and for core, this is the highest since June 1992. This is more than just base effects, as the m/m gains for headline and core were 0.6% and 0.7%, respectively, and compares to big April gains of 0.8% and 0.9%, respectively. The Fed continues to say this inflation is transitory. However, food and energy prices are soaring and are already feeding into higher core inflation. We suspect PPI data out next week will also surprise to the upside. Of note, the Fed’s preferred measure of core PCE came in at 3.1% y/y in April, the highest since July 1992 and above the 2% target.

Yet U.S. rates continue to fall. The 10-year UST yield has fallen to 1.43%, the lowest since March 3. The 10-year breakeven rate fell yesterday to as low as 2.31% but has since rebounded to 2.36% today. As a result, the real rate has fallen to -0.92% and matching the early May low. What’s noteworthy, however, is that the dollar has resumed its climb. There are many factors being cited with regards to the ongoing UST rally: strong foreign demand, strong domestic demand from fully-funded U.S. pension funds, and heightened confidence in the Fed. We suspect it is a combination of all three and then some. Yet when all is said and done, it is hard to justify U.S. yields remaining this low for much longer. Preliminary June University of Michigan consumer sentiment (84.2 expected) will be reported today.

Next week’s FOMC is coming into focus. We will be writing a preview Monday and we warn of a hawkish surprise. Is the Fed close to hiking? No. However, we see potential for a hawkish shift in the Dot Plots that moves median expectations for the first hike into 2023. We also believe that tapering may actually be mentioned in the official statement after informal discussions began at the last meeting in April. Lastly, the Fed will have to acknowledge the much higher than expected inflation numbers and its commitment not to let it get out of hand. For now, the markets believe the Fed but we suspect this trust will start to fray after several more months of very high inflation.

Weekly jobless claims data show continued healing of the labor market. Initial claims fell to 376k from 385k the previous week, while continuing claims fell to 3.499 mln vs. 3.757 mln the previous week. Both are post-pandemic lows as claims data continue to edge lower each week. Next week’s initial claims data will be for the BLS survey week containing the 12th of the month. If claims continue to fall, then another solid NFP number is likely. Of note, continuing claims are reported with a one week lag and so it will be the data the week after next that will be for the survey week.

Peru’s central bank left its target rate on hold at 0.25% last night, as expected, without any major changes in its guidance. The bank is keeping to the line of transitory inflation risks to justify its dovish bias, even keeping the possibility of additional stimulus on the table – though we doubt it will be necessary. Both headline (2.45% y/y) and core (1.8% y/y) measures have been rising but are not too far from the 2.0% mid-point of the target range. Elsewhere, the presidential elections are still undecided but leftist candidate Pedro Castillo appears highly likely to win. Markets have made their peace with this as seen by the recent gains in the sol and Peru’s CDS prices, in part following conciliatory words by Castillo on his economic policy. Protests and legal challenges against the elections results are a distinct possibility but we doubt it will have a lasting impact on markets.

EUROPE/MIDDLE EAST/AFRICA

The European Central Bank delivered a dovish hold, as expected. Rates were kept steady and the bank promised to maintain a “significantly higher” pace of purchases that was first announced at the March meeting. Growth and inflation forecasts were upgraded. Of note, the ECB forecasts 2021 inflation at 1.9% vs. 1.5% in March, 2022 inflation at 1.5% vs. 1.2% in March, and 2023 inflation at 1.4% vs. 1.4% in March. As Madame Lagarde pointed out, inflation is seen below target for the entire forecast horizon, which of course implies no rate hikes before 2024. Lagarde stressed that its asset purchases will be flexible and include seasonality. We think this was meant to address the fact that eurozone bond markets really thin out over the summer and so large asset purchases may not be needed to keep yields down. Lagarde is simply reminding us that we shouldn’t perceive smaller purchases over the summer to mean that the ECB is not serious about keeping yields down. Lastly, Lagarde said it was too early not to talk about winding down PEPP as the bank is far away from its inflation goals.

The U.K. data today were decidedly mixed. April GDP, IP, services, construction output, and trade were all reported. GDP rose 2.3% m/m vs. 2.4% expected, IP fell -1.3% m/m vs. 1.2% expected, services rose 3.4% m/m vs. 2.8% expected, and construction fell -2.0% m/m vs. 1.0% expected. A trade deficit of -GBP935 mln was posted vs -GBP2.5 bln expected. The U.K. economy continues to rebound strongly from the vaccination rollout and the subsequent reopening, but weakness in IP and construction is worth keeping an eye on.

Bank of England tightening expectations remain elevated as a result of the strong recovery. The short sterling futures strip suggests small odds of the first hike in Q4 2021, rising significantly in Q1 and Q2 and fully priced in by Q3 2022. Next decision is June 24 and no change is expected then. At the last decision May 6, the bank delivered a hawkish hold as rates were kept steady but tapering was started.

U.K. Prime Minister Johnson will reportedly delay the final stage of reopening. The official announcement will be made Monday as to whether the remaining curbs will be lifted as planned on June 21. Any delay risks a rift within his own party, as some have dubbed June 21 “Freedom Day” and oppose extending restrictions any longer. Yet his popularity and that of his Tory party remain high, even after ex-advisor Cummings’ testimony before parliament about the government’s pandemic response. Indeed, Johnson is basking in the spotlight as he hosts the G-7 summit.

The central bank of Russia hiked rates by 50 bps to 5.50%, as we had expected. The latest inflation figures came in at the high end of expectations at 6.0% y/y, the highest level since mid-2016 and further above the 4% target. Much of the increase came from higher food prices, but other categories such as consumer goods and services also accelerated. The ruble has been on a two-month strengthening trend, but the underlying inflation and recovery story will offset this. We think the cycle will likely go on for a few more meetings to at least 6.0% from 5.0% currently. There has been no reaction in the ruble or rates so far.

The recent lira gains have accelerated, possibly related to optimism about the upcoming Biden-Erdogan meeting. Some of the most recent communication from U.S. high-level diplomatic meetings (such as China and the UK) have sounded forward-looking and non-confrontational. Needless to say that U.S.-Turkey relation have a long list of items to go through (from Russia’s S-400 to the Khashoggi issue). However, the recent precedents bode well for a reconciliation, or at least some positive headlines. That said, it’s important to remember that there is still a lot of rancor in the U.S. Congress, so there is a long way to go. Either way, the lira has appreciated over the last six consecutive sessions, appreciating nearly 4% this week, but there is still a long way to go to recoup the losses over the last few months. Next week’s central bank meeting may refocus market attention on the fundamentals, which remain shaky.

ASIA

Bank of Korea is joining the fray of central banks that are signaling that tightening is on the way. Governor Lee Ju-yeol’s said “The current accommodative monetary policy should start to be normalized at an appropriate timing in an orderly fashion if our economy is forecast to continue its solid recovery.” Lee added that the timing will be determined by the virus outlook, the strength and durability of the recovery, and risks from financial imbalances. These comments overnight were also more optimistic about the economy. We note that this seems to have been already well priced in, at least in the bond markets, as seen by the strong upward trend in yields over the last several months. As usual, the bank remains concerned about private sector leverage, but this is not a new issue and seems manageable. Moreover, we don’t expect a fast paced, or even frontloaded, normalization, though the odds of a hike still this year are rising. Next policy meeting is July 15 and no change is expected then as it seems too soon.

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