Dollar Powers Ahead as U.S. Yields Rise

June 13, 2022

Win Thin

U.S. yields continue to rise; the rise in short-end U.S. yields reflects significantly higher Fed tightening expectations; portions of the U.S. yield curve have inverted again
Monthly U.K. data dump started out very weak; the BOE is expected to hike rates 25 bp to 1.25% when its meeting ends Thursday; Brexit remains in the headlines; markets are still digesting last week’s ECB decision as tightening expectations have picked up; we think the rising risks of fragmentation are a major factor behind subsequent euro weakness
The BOJ bought JGBs to defend its Yield Curve Control target; market dislocations come ahead of the BOJ meeting that ends Friday; China is reimposing some COVID restrictions as virus numbers rise

The dollar continues to gain. DXY is up for the fourth straight day and trading near 104.70. It is likely to soon test the May 13 high near 105. After that is the December 2002 high near 107.30. The euro is trading heavy near $1.0450 as fragmentation fears have risen in the wake of the ECB decision. The break below $1.0515 sets up a test of the May 13 low near $1.0350 and after that, we have to start talking about parity. The weakening trend in the yen continues as USD/JPY made a new cycle high today near 135.20 before rising official concern (see below) dragged it back to around 134.50. After the pair hit our long-standing target of the January 2002 high near 135.15, we believe it is on track to test the August 1998 high near 147.65. Sterling remains soft below $1.22 as the economy slides into recession and Brexit risks rise again (see below). Cable is nearing a test of the May 13 low near $1.2155. After that is the May 2020 low near $1.2075 but we continue to target the March 2020 low near $1.1410.

AMERICAS

U.S. yields continue to rise. The 10-year yield traded near 3.25% today, up from last month’s low near 2.70% but just shy of the October 2018 peak near 3.26%. As a result, the real 10-year yield has risen to 0.45%, the highest since June 2019. Elsewhere, the 2-year yield traded at a new cycle high near 3.25% today, up from last month’s low near 2.44% and the highest since December 2007. The 2-year differential with Germany has recovered to 210 bp after falling to 197 bp last week, the lowest since the end of February, while the 2-year gap with Japan has risen to a new cycle high near 324 bp, the highest since August 2007. When all is said and done, we believe monetary policy divergences remain the dominant driver for FX. As the U.S. economic outlook remains the best relative to its DM peers, the dollar uptrend remains intact.

The rise in short-end U.S. yields reflects significantly higher Fed tightening expectations. WIRP suggests 50 bp hikes are now fully priced in for June, July, September, and November. There are low odds (~25-30%) of 75 bp at these upcoming meetings. We note that some banks are raising their Fed calls for a 75 bp move, one for as early as this week. Is it possible? Sure, but we think it's very unlikely as there is going to be a very high bar after the Fed already flagged 50 bp moves for June and July. Have things really worsened that much? We say not really. Looking ahead, the swaps market is now pricing in a terminal rate near 4.0%, a new high and up from around 3.0% at the start of this month. This was the risk if inflation were to remain persistent and that's what we are seeing.

Portions of the U.S. yield curve have inverted again. The 2- to 10-year portion inverted briefly but has since returned to positive territory, while other portions remain inverted. We must stress yet again that the important curve to watch is the 3-month to 10-year and at 193 bp, it is nowhere close to inverting. Of course, incoming data need close monitoring but for now, we believe risks of a recession in the next 12 months are low. For a deeper discussion of U.S. yield curve dynamics, please see our piece from March here.

EUROPE/MIDDLE EAST/AFRICA

Monthly U.K. data dump started out very weak. April GDP came in at -0.3% m/m vs. 0.1% expected and -0.1% in March, IP came in at -0.6% m/m vs. 0.3% expected and -0.2% in March, services came in at -0.3% m/m vs. 0.1% expected and -0.2% in March, and construction came in at -0.4% m/m vs. -0.5% expected and 1.7% in March. The y/y rates all continue to slow as the U.K. economy inexorably slides towards recession. Consensus sees GDP staying flat q/q in Q2 but there are clearly downside risks after the April data. Lastly, the trade deficit came in at -GBP8.5 bln vs. -GBP10.8 bln expected and -GBP11.6 bln in March.

The Bank of England is expected to hike rates 25 bp to 1.25% when its meeting ends Thursday. WIRP now suggests around 40% odds of a 50 bp move, down from 55% before the weak data were reported. In addition, odds of 50 bp moves at the August 4 and November 3 meetings have also eased. The swaps market is still pricing in 250 bp of tightening over the next 12 months that would see the policy rate peak around 3.5% vs. 2.5% in late May. Yet despite the heightened expectations, sterling remains under pressure. Cable is about to test the May 13 low near $1.2155 and should go on to test the May 2020 low near $1.2075. After that, there aren’t any major chart points until the March 2020 low near $1.1410.

Brexit remains in the headlines. As reported last week, Northern Ireland Secretary Lewis confirmed Sunday that legislation allowing the government to unilaterally rewrite the Brexit agreement will be presented to Parliament today. This will be done with the hopes of passage before Parliament adjourns at the end of July. Ireland Foreign Secretary Coveney warned that the move would be “deeply damaging” to U.K. relations with Ireland and the EU, and reportedly accused U.K. Foreign Secretary Truss of not engaging in meaningful negotiations with the EU since February. Lastly, Coveney said “Far from fixing problems, this legislation will create a whole new set of uncertainties and damage relationships.” We concur as the EU is likely to respond swiftly with retaliatory tariffs. A potential trade war with its largest trading partner as the economy is already contracting is yet another reason we remain negative on sterling.

Markets are still digesting last week’s ECB decision as tightening expectations have picked up. WIRP suggests a 25 bp hike July 21 is fully priced in. Then, 50 bp hikes are nearly priced in for the next two meetings September 8 and October 27, followed by a 25 bp hike December 15 that would take the deposit rate to 1.0% by year-end. Looking ahead, the swaps market is now pricing in 275 bp of tightening over the next 24 months that would see the deposit rate peak near 2.25% vs. 1.75% before the meeting. Yet the euro remains soft. The break below $1.0515 sets up a test of the May 13 low near $1.0350. After that , we have to start talking about parity, something we haven’t seen since December 2002.

We think the rising risks of fragmentation are a major factor behind subsequent euro weakness. Markets were very disappointed by the lack of any concrete measures to address peripheral spreads, which are making new cycle highs as a result. Reports had hinted at some sort of new emergency bond-buying program but all we got was a pledge to use PEPP reinvestments to address the issue. That wasn't enough and so the euro is plumbing new depths. We may see some attempts at damage control but the ECB blew its chance last week to make a stronger statement.

ASIA

The Bank of Japan bought JGBs to defend its Yield Curve Control target. The 10-year JGB yield traded as high as 0.255% before the bank’s purchases pushed it back below the 0.25% ceiling under YCC. The bank said it will buy an additional JPY500 bln ($3.7 bln) of JGBs with maturities of 5-10 years tomorrow after it purchased JPY1.53 trln through its so-called fixed-rate operations today, the second-largest amount since it was introduced in September 2016. Elsewhere, USD/JPY traded at a new high for this move near 135.20, above the January 2002 high near 135.15. As we have pointed out many times before, there are no major chart points until the August 1998 high near 147.65. The pair fell back below 135 after Bank of Japan Kuroda expressed concern, noting “A recent rapid depreciation of the yen is undesirable and negative for the economy. They increase uncertainties and make it hard for businesses make plans.”

The market dislocations come ahead of the BOJ meeting that ends Friday. No change is expected and updated macro forecasts won’t be released until the next meeting July 21. While the bank is unlikely to signal any shift in its monetary stance this week, officials are likely to express more concern about renewed weakness in the yen. Yet as long as the BOJ remains ultra-dovish, the exchange rate will continue to weaken. Jawboning is all we are likely to see for now as any FX intervention would be going against the fundamentals and so likely doomed to failure.

China is reimposing some COVID restrictions as virus numbers rise. Policymakers delayed the reopening of most schools in Beijing planned for Monday, while most districts in Shanghai suspended dine-in services at restaurants. Data this week are expected to show some improvement in the economy but we warn that the recovery is likely to be uneven as restrictions will be enacted periodically to help limit any COVID outbreaks.

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