Dollar Gains as European Outlook Deteriorates

November 19, 2021
  • More and more Fed officials are talking about 2022 liftoff; we believe the dollar’s next leg higher will be driven by market repricing of tightening in the rest of the world; regional Fed manufacturing surveys for November have so far come in firm; Canada reports September retail sales
  • The virus news stream from Europe continues to deteriorate; ECB President Lagarde today warned that the bank mustn’t tighten too soon despite “unwelcome and painful” inflation; U.K. reported strong October retail sales; Brexit talks continue today in Brussels; South Africa hiked rates 25 bp to 3.75%, as expected most analysts
  • Japan reported October national CPI; EM Asia credit spreads are converging fast to the broader EM space as concerns about China’s financial sector recede

The dollar rally has resumed. After two straight down days, DXY is trading higher near 96 and on track to test this week’s cycle high near 96.241. We look for further gains and the June 2020 high near 97.802 is coming into focus. Similarly, the euro is trading back below $1.13 and on track to test this week’s cycle low near $1.1265. Here, the next major chart point is the June 2020 low near $1.1170. Sterling is softer despite firm U.K. retail sales data (see below). Break of support seen all week near $1.34 would set up a test of the December 2020 low near $1.3135. USD/JPY remains heavy and is trading just below 114 after trading just shy of 115 earlier this week. Eventually, this pair should play catchup and this week’s break above last month's high near 114.70 sets up a test of the December 2016 high near 118.65. We believe the fundamental backdrop continues to favor the dollar.


More and more Fed officials are talking about 2022 liftoff. Yesterday, Bostic said it would be appropriate to start hiking rates around next summer, noting that “Right now, our projections suggest that by the summertime of next year, the number of jobs that we have in the economy will be pretty much where we were pre-pandemic. And at that point, I think it’s appropriate for us to try to normalize our interest rate policy.” Elsewhere, Evans said liftoff “could begin next year after we finish our asset-purchasing program, or it could be as long as into 2023.” Market expectations have been remarkably stable in recent weeks, with liftoff in Q3 and a follow-up hike in Q4 both fully priced in. Odds of Q2 liftoff have fluctuated a bit but remains near 50-50. We view Q2 as too soon but believe the swaps market is correct in pricing in 50 bp of tightening over the next twelve months. Waller and Clarida speak today.

We believe the dollar’s next leg higher will be driven by market repricing of tightening in the rest of the world. Over the next twelve months, swaps market sees 125 bp of tighten by BOC, 5 bp by ECB, 100 bp by BOE, 25 bp by SNB, 100 bp by Norges Bank, 50 bp by Riksbank, 75 bp by RBA, 200 bp by RBNZ, and none by BOJ. We believe that pricing is too aggressive in most cases. The likely exceptions are ECB and BOJ, which we think are correctly priced for steady rates. With the virus still tearing through many parts of the world (see below), we believe it is naïve to believe that we can get full normalization of monetary policy in the next year or two.

Regional Fed manufacturing surveys for November have so far come in firm. Yesterday, Philly Fed came in at 39.0 vs. 24.0 expected and 23.8 in October, while Kansas City Fed came in at 24 vs. 28 expected and 31 in October. Earlier in the week, Empire survey came in at 30.9 vs. 22.0 expected and 19.8 in October. The U.S. economy is likely to rebound strongly in Q4 and that should maintain upward pressure on U.S. yields and the dollar even as Europe sputters (see below).

Canada reports September retail sales. Headline sales are expected at -1.7% m/m vs. 2.1% in August, while sales ex-auto are expected at -1.0% m/m vs. 2.8% in August. Bank of Canada liftoff expectations have risen after it moved its forward guidance to Q2 from H2 2022 previously at its last meeting. WIRP suggests 50-50 odds of a hike January 26, moving up to nearly fully priced in March 2. This still seems too aggressive to us and so we expect the BOC to push back a bit at its next meeting December 8. Of note, lower oil prices are likely to be a growing headwind for the economy as we move into 2022 and so the BOC should be a bit more cautious.


The virus news stream from Europe continues to deteriorate. Austria announced a nationwide lockdown after earlier efforts to restrict movement of the unvaccinated failed to stem the rise in infections. The nation will also become the first in Europe to mandate vaccinations. Elsewhere, German health officials signaled that they are moving in the same direction, with Health Minister Spahn saying “We’re in a situation in which we shouldn’t rule anything out.” Earlier this week, Germany also announced plans to restrict movement of the unvaccinated but seems likely to follow Austria in announcing even stricter measures. Italy is seeing a sharp increase in virus numbers as well. It’s clear that the eurozone economy faces significant risk of a Q4 contraction.

ECB President Lagarde today warned that the bank mustn’t tighten too soon despite “unwelcome and painful” inflation. This comes even as October German PPI Friday came in hot, rising 18.4% y/y vs. 16.2% expected and 14.2% in September. This points to further upward pressure on German CPI, which rose 4.6% y/y EU Harmonized in October. With Europe suffering from a fourth wave of infections, we believe Lagarde has the upper hand despite a very vocal contingent of ECB hawks. We expect the ECB to announce at the December 16 meeting an extension of QE in some manner after PEPP is set to expire in March. Weidmann also speaks today and is likely to maintain his hawkish stance.

U.K. reported strong October retail sales. Headline sales rose 0.8% m/m vs. 0.5% expected and a revised flat reading (was -0.2%) in September, while sales ex-auto fuel jumped 1.6% m/m vs. 0.6% expected and a revised -0.4% (was -0.6%) in September. This was the first monthly gain in sales since April, with many stores reporting an early start to Christmas shopping. This bears watching, as consumers may merely be reacting to dire warnings of shortages during the holiday season. If so, then we would expect to see a sharp drop-off in December and January. Stay tuned. Elsewhere, public sector net borrowing data came in a bit higher than expected. Ex-banking groups, the figure was GBP18.8 bln vs. GBP14.0 bln expected and a revised GBP20.7 bln (was 21.8 bln) in September. WIRP suggests Bank of England liftoff December 16 remains 50-50. However, February 3 liftoff is fully priced in.

Brexit talks continue today in Brussels. A European Commission briefing this week reportedly saw lower risks of the U.K. unilaterally rejecting parts of the Northern Ireland Protocol, adding that the EU’s tougher stance was a major factor. U.K. Brexit Minister Frost pushed back by saying “I would suggest that our friends in the EU don’t interpret the reasonable tone that I usually use in my discussions with them as implying any softening in the substantive position. Whatever messages to the contrary the EU may think they’ve heard or read, our position has not changed.” That said, officials on both sides acknowledge an improved tone in the talks and so we are hopeful that a negotiated settlement will eventually be reached.

The South African Reserve Bank hiked rates 25 bp to 3.75%, as expected most analysts. However, it was a 3-2 split decision. The lack of consensus suggests that the SARB's rather hawkish rate path will be difficult to meet. The FX market didn't like the signal, with USD/ZAR now at the highs for the year. The bank’s model sees the repo rate at just over 6.0% by the end-2023, a hike in each quarter of 2022, 2023 and 2024. There’s also the risk of a downgrade by Moody’s this week but promises for fiscal consolidating will probably be enough to avoid this outcome, at least for now.


Japan reported October national CPI. Headline inflation was expected to remain steady at 0.2% y/y but instead fell a tick to 0.1%, while core (ex-fresh food) remained steady as expected at 0.1% y/y. It truly is astounding how Japan stands out as the only major economy not to be experiencing sharply higher inflation. Much of that is due to the culture of deflation that has held for decades, with firms having little to no pricing power with consumers. With PPI rising sharply, that means profit margins are getting squeezed. November Tokyo CPI will be reported next Friday, with both headline and core expected to pick up to 0.4% y/y and 0.3% y/y from 0.1% for both in October, respectively.

EM Asia credit spreads are converging fast to the broader EM space as concerns about China’s financial sector recede. It’s been the strongest 2-week rally in over a year, according to Bloomberg data, with yields on the aggregate Asia index falling over 20 bp. This came as issuance from the region came in over $11 bln. The main culprit here is the better sentiment towards Chinese builders, a significant component of the index. As we said from the start of the Evergrande saga, the government would likely step in to avoid forced liquidation, even at the cost of significant moral hazard.

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