Dollar Gains as Impact of BOE Bond-Buying Plan Wanes

September 29, 2022

Win Thin

Global bond yields dropped yesterday in sympathy with the U.K. but are rising today; reports suggest that the Biden administration is concerned about the market spillovers stemming from the U.K. tax plan; Fed officials remain hawkish; Mexico is expected to hike rates 75 bp to 9.25%; Colombia is expected to hike rates 150 bp to 10.5%
Markets have calmed somewhat after the Bank of England’s emergency bond-buying plan was announced; Prime Minister Truss doubled down on her tax plan in her first public remarks since the turmoil began; September eurozone CPI readings started rolling out; Czech National Bank is expected to keep rates steady at 7.0%
Australia reported its first monthly CPI reading; RBA Deputy Governor Bullock recently said that the new monthly data are unlikely to influence policy initially

The dollar has rebounded as the impact of the BOE bond-buying plans wears off. Global equity markets are lower and global bond yields are higher. DXY is up today and trading near 113.259 after yesterday’s drop broke a streak of six straight up days. We expect an eventual test of yesterday’s new cycle high near 114.778. Sterling feels heavy as it has been unable to make any headway above $1.09 this week. With the Truss government sticking with its disastrous fiscal plan (see below), we look for an eventual test of this week’s new all-time low near $1.0350. The euro remains heavy as it has been unable to break above the $0.9750 area this week. The fundamentals remain poor and so we look for an eventual test of this week’s new cycle low near $0.9535. USD/JPY continues to trade just below 145 but we believe markets are likely to soon test the BOJ’s resolve. The combination of ongoing risk off impulses and repricing of Fed tightening risks is likely to keep the dollar bid across the board near-term. With the outlook for the rest of the world still worsening, the global backdrop continues to favor the dollar and U.S. assets in general.

AMERICAS

Global bond yields dropped yesterday in sympathy with the U.K. but are rising today. U.K. gilt yields in particular are rising again as markets realize the limits of the BOE’s emergency bond-buying (see below). In the U.S., the 10-year yield fell to as low as 3.69% yesterday from 4.02% but is currently around 3.84%, while the 2-year yield fell to as low as 4.08% yesterday from 4.31% but is currently around 4.20%. Such big moves being driven by the U.K. just don’t make much sense. At around $3 trln, the U.K. economy is a fraction of the U.S. at $23 trln, China at $18 trln, the eurozone at $14.5 trln, and Japan at $5 trln. BIS estimates the size of the U.S. Treasury market at $22 trln. This is by far the largest and compares to Japan at $8.5 trln and China at $8.4 trln. The U.K. comes in at around $3 trln. It seems a bit crazy that what’s going on in a small island economy can have such a large global impact but here we are. That said, we believe the Fed tightening path will see U.S. yields resume their climb once the dust settles.

Reports suggest that the Biden administration is concerned about the market spillovers stemming from the U.K. tax plan. U.S. Treasury officials are reportedly working through the IMF to apply pressure on the Truss government to rethink the plan. As noted yesterday, the IMF has already weighed in. Treasury Secretary Yellen declined to directly address the U.K. this week but Commerce Secretary Raimondo said the U.K. plan was misguided and added “The policy of cutting taxes and simultaneously increasing spending isn’t one that’s going to fight inflation in the short term or put you in good stead for longer-term economic growth.” We concur.

Fed tightening expectations have fallen a bit. WIRP suggests another 75 bp hike is only about 70% fully priced in for November 2, as is a follow-up 50 bp hike December 14. Elsewhere, the swaps market is pricing in a terminal rate of 4.5%. The generalized increase in U.S. yields is likely to resume and will ultimately support the dollar. Of note, the 3-month to 10-year curve remains positively sloped near 50 bp, the steepest since July, and so we are not yet ready to call for an imminent recession in the U.S.

Fed officials remain hawkish. Bullard, Mester, and Daly speak today. Yesterday, Bostic said “The lack of progress thus far has me thinking much more now that we have to get to a moderately restrictive stance. And for me, that is in the 4.25% to 4.5% range for our policy. My preference is that we get there by year end.” Evans acknowledged that high global market volatility “can add to additional financial restrictiveness” but added “The risks continue to be high about more persistent inflation, and we just really need to get inflation in check.” This suggests he will not let global market gyrations derail the Fed’s tightening plans.

We get another look at Q2 GDP. Consensus sees no change at -0.6% SAAR. Of course, this is old news and markets are already looking ahead to Q3 and Q4. The Atlanta Fed’s GDPNow model is currently tracking Q3 growth at 0.3% SAAR, down from 0.5% previously. The next model update will be this Friday. Of note, Bloomberg consensus sees Q3 at 1.4% SAAR and Q4 at 1.0% SAAR.

Weekly jobless claims will be closely watched. Initial claims are expected at 215k vs. 213k last week, which were for the BLS survey week containing the 12th of the month. That was the lowest since late May while the four-week moving average of 217k was the lowest since early June. Continuing claims are reported with a one-week lag and so this week’s reading will be for the BLS survey week. These claims are expected at 1.385 mln vs. 1.379 mln last week, the lowest since mid-July. The recent claims data point to continued resilience in the labor market. Current consensus for September NFP next Friday is 250k vs. 315k in August but there are still many more clues to come.

Banco de Mexico is expected to hike rates 75 bp to 9.25%. At the last meeting August 11, it hiked 75 bp and said it “will assess the magnitude of the upward adjustments in the reference rate for its next policy decisions based on the prevailing conditions.” While some felt this would allow the bank to slow its pace of hiking, the data have not warranted it. CPI rose 8.70% y/y in September, the highest since December 2000 and further above the 2-4% target range. The swaps market is pricing in 200 bp of tightening over the next 6 months that would see the policy rate peak near 10.5%.

Colombia central bank is expected to hike rates 150 bp to 10.5%. However, a third of the analysts polled by Bloomberg look for smaller 100 or 125 bp moves. At the last policy meeting July 29, the bank hiked 150 bp to 9.0%. Governor Villar said then that “The excess of demand continues, with economic activity that remains strong. World inflation has continued to increased, and acquired a greater persistence.” Since then, CPI picked up to 10.84% y/y in August, the highest since April 1999 and further above the 2-4% target range. The swaps market is pricing in 300 bp of tightening over the next 6 months that would see the policy rate peak near 12.0%.

EUROPE/MIDDLE EAST/AFRICA

Markets have calmed somewhat after the Bank of England’s emergency bond-buying plan was announced. More details have emerged. The bank said it acted due to concerns that margin calls yesterday would trigger a crash in the gilt market. The BOE said purchases will be up to GBP5 bln per operation but that the parameters of the temporary program will be kept under review. To us, this is similar in spirit to what the Fed did in summer 2019 when interbank funding was seizing up because the Fed's balance sheet shrinkage pushed excess bank reserves too low for the market to function normally. The Fed took pains to say it wasn't QE but its balance sheet grew anyway. Either way, the symptom (dislocations in the gilt market) may have been addressed but the underlying malady (irresponsible fiscal policy) continues to fester.

Indeed, Prime Minister Truss doubled down on her tax plan in her first public remarks since the turmoil began. Today she said that “We’re facing very, very difficult economic times, we’re facing that on a global level. We had to take urgent action to get our economy growing and that means taking controversial and difficult decisions.” Truss stressed that “I’m very clear the government has done the right thing. This is the right plan.” Former BOE Governor Carney was quite critical of the plan, noting “The message of financial markets is that there is a limit to unfunded spending and unfunded tax cuts in this environment. And the price of those is much higher borrowing costs for the government and for mortgage holders and borrowers up and down the country.” He was even more critical of Truss, accusing her government of “undercutting” the U.K.’s economic institutions.

Bank of England tightening expectations remain elevated as a result of the planned fiscal stimulus. Is there anything the BOE can do to support the pound? They just met last week and hiked a lackluster 50 bp but would 75 or 100 bp really have made much difference? Sentiment was already poor but the tax package simply poured gasoline on the fire. We don't think any sort of emergency BOE rate hike would do much to support the currency beyond a brief knee-jerk reaction. As it is, WIRP suggests a 150 bp hike is fully priced in for November 3 while the swaps market is pricing in a peak policy rate near 6.0% over the next 12 months, up from 4.5-4.75% at the start of last week.

September eurozone CPI readings started rolling out. Spain reported EU Harmonized CPI at 9.3% y/y vs. 10.0% expected and 10.5% in August. This was the second straight month of deceleration to the lowest since May. Core inflation also decelerated to 6.2% y/y vs. 6.6% expected and 6.4% in August. Germany reports later today and EU Harmonized CPI is expected at 10.2% y/y vs. 8.8% in August. However, German state data already reported today suggest upside risks. France, Italy, and eurozone CPI will be reported tomorrow. EU Harmonized CPI for France is expected to remain steady at 6.6% y/y and Italy is expected at 9.5% y/y vs. 9.1% in August. For the eurozone as a whole, headline inflation is expected at 9.7% y/y vs. 9.1% in August and core is expected at 4.7% y/y vs. 4.3% in August.

ECB tightening expectations have fallen slightly. WIRP suggests another 75 bp is almost full priced in for the next meeting October 27, while the swaps market is pricing in 2225 bp of tightening over the next 12 months that would see the deposit rate peak near 3.0%, down from 3.25% at the start of this week but up from 2.75% at the start of last week.

Czech National Bank is expected to keep rates steady at 7.0%. At the last meeting August 4, the bank delivered a dovish surprise and kept rates steady at 7.0% vs. an expected 25 bp hike. The vote was 5-2, with the two dissents in favor of a 100 bp hike. New Governor Michl said that curbing inflation is the bank’s top priority, but shifted its policy framework to get inflation back to target within 18-24 months vs. 12-18 months previously. The swaps market sees steady rates over the next 12 months, followed by the start of an easing cycle over the subsequent 12 months. A 7% nominal policy when inflation is 17.2% doesn't seem to be restrictive enough and so we see upside risks to the policy rate.

ASIA

Australia reported its first monthly CPI reading. The y/y rate for August came in at 6.8% vs. 7.0% in July an 6.8% in June. ABS official noted “The information released today provides an early indication of September quarter CPI inflation that will be published on 26 October 2022. The new monthly CPI indicator publication will also be released on 26 October and will include data up to the month of September.” There is no consensus out for Q3 CPI yet but taking a simple average of the two months reported here suggests something around 6.9% y/y vs. 6.1% in Q2. Of note, CPI excluding fruit, vegetables, and fuel picked up from 5.5% y/y in June to 6.2% in August, suggesting that core inflation will pick up in Q3 as well.

RBA Deputy Governor Bullock recently said that the new monthly data are unlikely to influence policy initially. She added that bank officials will want to see several months of releases in order to better understand the series. Bullock also said last week that the RBA still forecasts inflation to peak between 7.75-8.0% early next year, which is consistent with the bank’s August projections. Updated forecasts will come at the November 1 meeting. For now, the RBA is likely to continue on its tightening path. WIRP suggests nearly 60% odds of a 50 bp hike October 4, while the swaps market is pricing in 210 bp of tightening over the next 12 months that would see the policy rate peak near 4.45%. Yet this has done nothing for AUD, which traded at a new cycle low yesterday near .6365 and on track to test the March 2020 low near .5510.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2022. All rights reserved.