Dollar Firms as Key Central Bank Week Begins

December 13, 2021

To say this is an eventful week would be an understatement; we continue to take issue with market pricing for a terminal Fed Funds rate of 1.5%; today is a quiet day before the storm of central bank meetings hits
U.K. raised its Covid alert level from 3 to 4 as Prime Minister Johnson warned of a ‘tidal wave’ of omicron cases; TRY continues to collapse after S&P’s downgrade late Friday
BOJ Tankan survey for Q4 was mixed; PBOC continues to signal discomfort with yuan appreciation by setting the fixing on the weaker side

The dollar is regaining some traction. DXY traded today near 96.50, just shy of last week’s high near 96.60. The November cycle high near 96.938 remains in sight. The euro remains heavy after last week’s bounce ran out of steam near $1.1350, and is trading back below $1.13. We continue to look for an eventual test of the November cycle low near $1.1185. Sterling remains heavy as economic and political woes mount, trading near $1.3250 and still on track to test last week’s cycle low near $1.3165. USD/JPY remains stuck in a narrow trading range below 114 and remains subject to bouts of risk-off selling. We believe the underlying trend for a stronger dollar remains intact as an incredibly important week gets under way.

AMERICAS

To say this is an eventful week would be an understatement. According to Bloomberg, there are 20 central bank meetings this week. While the Fed is obviously the most important, the BOE and ECB will also be important in setting market expectations for next year. We believe the central bank divergence story will remain a key driver for currency markets in 2022 and we will be focusing on this in our upcoming FX Quarterly. Simply put, the hawkish Fed outlook is likely to keep the dollar rally on trace as we move into next year.

That said, we continue to take issue with market pricing for a terminal Fed Funds rate of 1.5%. If inflation were to return to the 2% target, this would imply a negative real policy rate at the end of a Fed tightening cycle, which is something unheard of. If the labor market is as tight as we fear, it seems that the risks to the terminal rate are tilted to the upside. In the September Dots, 1 policymaker saw a longer-term Fed Funds rates of 2.0%, 4 saw 2.25%, 1 saw 2.375%, 9 saw 2.5%, and 2 saw 3.0%. How can markets reconcile this with a 1.5% terminal rate? They can’t, and when markets realize this, that should give the dollar another leg higher.

Today is a quiet day before the storm of central bank meetings hits. There are no U.S. data releases nor Fed speakers today. Global equity markets are higher, while bond yields are lower. The dollar is asserting its dominance ahead of the FOMC decision, which is keeping EM currencies on the back foot. We remain concerned that EM and other risk products are not fully prepared for the quick removal of Fed stimulus in the coming months.

EUROPE/MIDDLE EAST/AFRICA

The U.K. raised its Covid alert level from 3 to 4 as Prime Minister Johnson warned of a ‘tidal wave’ of omicron cases. Johnson announced an accelerated vaccine booster program and will deploy military planning teams to help with the rollout. Health Secretary Javid said he cannot be certain that schools will remain open, noting “When it comes to our fight against the pandemic there are no guarantees. We are once again in a race between the vaccine and the virus.” Weekend polls put the Labour party well ahead of the Tories for the first time in seven years, ahead of a by-election Thursday. This seat is usually considered reliably safe for the Tories but given the current backdrop, all bets are off. Over the weekend, reports emerged that Johnson had hosted some sort of holiday gathering last December that was separated from the previously documented gathering by cabinet members.

The lira continues to collapse after S&P’s downgrade late Friday. This despite a rare bit of good news for Turkey, as the current account surplus came in well above expectations. The October figure came in at $3.16 bln vs $2.5 bln expected and $1.67 bln in September. The upside surprise came partially from a recovery in the service sector balance and strong exports. The data did little to aid the currency, down 3% on the day and blasting thought the TRY14 level. The central bank has continued to intervene to soften the blow but this is akin to putting a band-aid on a gaping wound. Today’s price action is in part due to S&P cutting the outlook on Turkey’s B+ rating from stable to negative late Friday due to “extreme currency volatility.” Of note, Moody’s rates Turkey B2 (equivalent to B) while Fitch has it at a very generous BB-.

ASIA

Bank of Japan Tankan survey for Q4 was mixed. Large manufacturing index came in at 18 vs. 19 expected and 18 in Q3, while the large manufacturing outlook came in at 13 vs. 19 expected and 14 in Q3. On the other hand, large non-manufacturing index came in at 9 vs 5 expected and 2 in Q3, while the large manufacturing outlook came in at 8 vs. 9 expected and 3 in Q3. Lastly, large all industry capex came in at 9.3% vs. 9.8% and 10.1% in Q3. Basically, the survey suggests that while things are looking good now, the outlook for 2022 remains cloudy for both manufacturing and non-manufacturing firms in Japan. The discovery of the omicron variant may not be fully captured in this survey as most of the firms had already responded by the time it was widely reported. October core machine orders were also reported and came in at 3.8% m/m vs. 1.8% expected and a flat reading in September. Data come ahead of this Friday’s BOJ decision, which is widely expected to deliver a dovish hold.

The PBOC continues to signal discomfort with yuan appreciation by setting the fixing on the weaker side. Recall that last Friday, the PBOC raised foreign exchange reserve requirements for its commercial banks. We don’t think there is any major FX policy change underway here, but we have seen an unusual divergence between the yuan’s trajectory and the broad dollar trend over the last couple of months. This is all part of a concerted effort to increase economic stimulus next year by pulling on the several levers available to policymakers. We remain of the view that fiscal stimulus is forthcoming, albeit targeted to specific sectors.

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