Dollar Recoups Some Losses as U.S. Returns From Holiday

November 14, 2022

Win Thin

Markets are still digesting last week’s CPI report; the market reaction last week seems outsized relative to the actual repricing of Fed tightening expectations; the U.S. yield curve remains inverted; Fed speakers this week will be closely watched
Reports suggest U.K. Chancellor Hunt will delay the bulk of planned fiscal tightening until after the next election; BOE tightening expectations are still adjusting; eurozone reported firm September IP; ECB tightening expectations have been pared back
BOJ Governor Kuroda said he will be looking at both upside and downside risks as the bank sets policy; China unveiled a 16-point rescue package for the property sector; Presidents Biden and Xi met in an effort to ease tensions

The dollar has recouped some of its recent losses. DXY is up for the first time after two straight down days and is trading near 107.185. The euro rally ran out of steam at the August 10 high near $1.0370 and is trading back below $1.03. Cable made another new high for this move today near $1.1870 but was unable to break above the August 26 high near $1.19 and is trading back below $1.18. USD/JPY has bounced after being unable to break below 138.50 the last two days and is now trading near 140.60. We continue to believe that the outsized market reaction to the CPI data was unwarranted but acknowledge that the dollar may remain under pressure near-term as the Fed outlook continues to evolve.

AMERICAS

Markets are still digesting last week’s CPI report. The U.S. 2-year yield traded as low as 4.29% Thursday vs. the 4.80% cycle peak from last week but traded as high as 4.42% today. The 10-year yield traded as low as 3.81% Thursday vs. the 4.34% cycle peak from last October but traded as high as 3.90% today. The U.S. bond market was closed Friday for holiday and it ma y take a day or two before we get back to “normal.” Equity markets latched onto the data and never looked back. Last week, the S&P 500 was up nearly 6% while the NASDAQ was up over 8%. Futures point to a lower open today. DXY fell over 4% last week but has recovered nearly 1% today. Expect a lot of volatile and choppy moves across all markets this week.

We stress again that the market reaction last week seems outsized relative to the actual repricing of Fed tightening expectations. WIRP now suggests a 50 bp hike remains fully priced in but there are no longer any odds (for now) of a larger 75 bp move. Before the CPI data, there were only around 25% odds of a 75 bp hike. The swaps market is now pricing in a terminal rate near 5.0%, down from the 5.25% peak early last week. Easing expectations have picked up slightly, with the Fed Funds rate now seen near 4.75% in 12 months, down from 5.0% early last week. The rate is seen between 3.5-3.75% in 24 months, down from 4.0% early last week. These are not huge adjustments in Fed expectations and so it’s hard to justify just how much equity, bond, and FX markets moved last week. Before the December 13-14 meeting, we will get one more each of the jobs report, CPI, core PCE, and retail sales data along with two more PPI reports and so Fed expectations are likely to continue adjusting.

The U.S. yield curve remains inverted. Our favored curve is the 3-month to 10-yaer and after flirting with inversion the past couple of weeks, it has inverted deeply to the tune of -26 bp though up from last week’s low near -34 bp that was the most since September 2019. The 2- to 10-year curve has been inverted since July and is currently near -49 bp, just above the cycle low near -57 bp from early November. We await confirmation from the Chicago Fed National Activity Index but it seems that the U.S. economy is likely to go into recession over the next 12 months or so. Should equities really be rallying so much?

Fed speakers this week will be closely watched. Waller spoke Sunday and said “These rates are going to stay -- keep going up -- and they’re going to stay high for a while until we see this inflation get down closer to our target. We’ve still got a ways to go. This isn’t ending in the next meeting or two.” He added “It’s good finally that we saw some evidence of inflation starting to come down. We’re going to need to see a continued run of this kind of behavior on inflation slowly starting to come down before we really start thinking about taking our foot off the brakes here.” He stressed that “7.7% CPI inflation is enormous. It’s really not so much about the pace anymore, it’s where we’re going end up. And where we end is going to be driven solely by what happens with inflation.” Brainard and Williams speak today. There are no U.S. data reports today.

EUROPE/MIDDLE EAST/AFRICA

Reports suggest U.K. Chancellor Hunt will delay the bulk of planned fiscal tightening until after the next election. Hunt will deliver his autumn budget statement this Thursday. Reports suggest that around 40% of the GBP55 bln savings will come from tax hikes and 60% from spending cuts. The latest reports suggest that the bulk will be delivered in the final years of the five-year forecast to help the economy better cope with the imminent recession. If so, this would be an obvious attempt to shore up popular support for the Tories and minimize the impact on jobs in order to buy some time before the next general election must be called by January 2025. That said, there is an economic case to be made for trying to minimize pro-cyclical fiscal policy in a time of recession. It’s just not clear whether the markets will give Hunt the leeway to do so after so much credibility was lost under Kwarteng. Stay tuned.

Bank of England tightening expectations are still adjusting. WIRP suggests a 50 bp hike December 15 is priced in, with 45% odds of a larger 75 bp hike, down from over 60% at the start of last week. The swaps market is pricing in 150 bp of tightening over the next 12 months that would see the policy rate peak near 4.5%, down from 4.75% last week, and down sharply from 6.25% right after the mini-budget in late September.

Eurozone reported firm September IP. It came in at 0.9% m/m vs. 0.5% expected and a revised 2.0% (was 1.5%) in August. As a result, the y/y rate improve to 4.9% vs. 3.0% expected and a revised 2.8% (was 2.5%) in August. The recovery in September was driven in large part by Germany and France. That said, Germany remains the weak link in the eurozone and we know that Q4 and Q1 will show further weakness.

ECB tightening expectations have been pared back. WIRP suggests another 75 bp is about 45% priced in for December 15 vs. fully priced in after the October decision, while the swaps market is pricing in a peak policy rate near 3.0% vs. 3.5-3.75% after the October decision. The ECB will update its macro forecasts at the December meeting and are likely to show similar revisions as the EU unveiled last week. 2025 will be added to the ECB’s forecast horizon then. We think there is still room for ECB tightening expectations to fall further and we stand by our call that the ECB will pivot and cut rates before the Fed does. Panetta, Centeno, Guindos, and Villeroy speak today. Panetta said that “Being prudent does not rule out the possibility of us having to move from withdrawing accommodation to restricting demand. But in the absence of clear second-round effects, we would need convincing evidence that the current shocks are likely to keep having a more adverse effect on supply than on demand.”

ASIA

Bank of Japan Governor Kuroda said he will be looking at both upside and downside risks as the bank sets policy. Specifically, he said that “The bank will closely examine the outlook for economic activity and prices, as well as the upside and downside risks to the outlook. Based on the assessments, it will conduct appropriate monetary policy.” This is a subtle shift in his tone in that he is finally recognizing possible upside risks to inflation. That said, Kuroda reiterated his view that the economy is still recovering from the pandemic and still needs support from monetary policy now. Last week, Kuroda said that conditions toward meeting its 2% inflation target are starting to emerge and that meeting the target will depend in large part on the pace of wage growth in FY23. It appears he is laying the groundwork for his successor to eventually remove accommodation, which we view as possible in H2 next year.

Late Friday, China unveiled a 16-point rescue package for the property sector. The People’s Bank of China and the China Banking and Insurance Regulatory Commission jointly issued a notice to local financial institutions laying out their plans to help ensure the “stable and healthy development” of the property sector. The major thrust of the package is to extend, extend, extend. Outstanding bank loans to property developers due within the next six months can be extended for a year, while repayment on their outstanding bonds can also be extended or swapped through negotiations. Banks were encouraged to negotiate with homeowners and to extend mortgage repayments if needed. A restriction on bank lending to developers can be “temporarily” lifted. Bottom line: after many false starts and mixed signals, policymakers are finally taking measures to support the troubled property sector. The bad news is that throwing more resources at a sector that is seeing its bubble burst is not really a viable long-term solution. At some point, there needs to be a deep washout of this sector in order to address long-standing imbalances. For now, however, policymakers seem content to kick the can down the road yet again.

Presidents Biden and Xi met in an effort to ease tensions. The meeting was on the sidelines of the G20 summit in Bali and was the first in person meeting for leadership since the pandemic began. Both sides said all the right things but the issues dividing the two nations remain vast. However, the meeting is at least a step towards maintaining open channels of communication. Before meeting Xi, Biden met with the leaders of Japan, South Korea, and Australia, key allies in the U.S. effort to counter China’s growing influence in the region.

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.