Dollar Remains Firm Post-FOMC

June 18, 2021
  • Meetings this week underscore our long-standing call for widening central bank divergences; at the heart of the matter is that those economies that were in strong shape before the pandemic are seeing strong recoveries; markets seem to be especially fixated in the huge move in the 5- to 30-year part of the U.S. Treasury curve; weekly jobless claims data were disappointing
  • U.K. reported very weak May retail sales; U.K. infections are rising; TRY is outperforming on the day but is still net weaker in the aftermath of the FOMC and the CBRT meetings
  • BOJ kept policy unchanged, as expected; ahead of the decision, May national CPI was reported; RBA estimates that QE has reduced yields on longer-term bonds by about 30 bp

The dollar remains bid. DXY traded today at the highest since April 13 near 92.07 and the break above 91.946 sets up a test of the March 31 high near 93.437. Likewise, the euro broke below $1.1920 and sets up a test of the March 31 low near $1.1705. Sterling is underperforming as U.K. virus numbers rise (see below), trading as low as $1.3855 today. The break below $1.3890 sets up a test of the April 12 low near $1.3670. Lastly, USD/JPY is trading just above 110 after posting a new cycle high yesterday near 110.80.

Emerging markets currencies didn’t escape the recent stronger dollar adjustment, but local bonds have fared relatively well. The spread between major EM and DM local currency indices has been on a widening trend for several quarters now as markets adjust to the coming inflationary pressures. But we take conform from seeing that there has been no acceleration in the divergence or any major fall out from recent events. We still think that EMs with central banks frontloading their tightening cycle (like Brazil and Russia) will be rewarded in this initial stage of adjustment compared to those who may fall behind (like Poland and South Africa).

AMERICAS

Meetings this week underscore our long-standing call for widening central bank divergences. The Fed and Norges Bank showed their hawkish credentials, while BOJ and SNB remain firmly entrenched in the dovish camp. And this simply continues the trend seen in recent weeks, with ECB delivering a dovish hold last week while BOE and BOC are already tapering. These divergences will surely grow in H2 and will be one of the major drivers for markets. With the Fed moving into the hawkish camp, this underpins our bullish dollar call.

At the heart of the matter is that those economies that were in strong shape before the pandemic are seeing strong recoveries. These include the U.S., U.K., Canada, Australia, New Zealand, and Norway. As a result, these central banks are removing or about to remove accommodation. On the other hand, the eurozone, Japan, Switzerland, and Sweden were all struggling with deflation before the pandemic and so their recoveries are shaping up to be more vulnerable and spottier.

Markets seem to be especially fixated in the huge move in the 5- to 30-year part of the U.S. Treasury curve. This was a popular expression of the reflation trade as it captured some risks that the Fed’s credibility being challenged, and inflation would become unanchored. As a result, positioning surely has played a role in the over 20 bp flattening seen over the last few sessions. Fundamentally speaking, the move seems to confirm that markets are fully embracing the narrative of short-term inflation risks that are now very likely under control thanks to a more assertive Fed. Does this mean the Fed will manage to avoid a Taper Tantrum? Stay tuned.

Weekly jobless claims data were disappointing. Initial claims rose to 412k vs. 360k expected and a revised 375k (was 376k) the previous week, while continuing claims rose to 3.518 mln vs. 3.425 mln expected and a revised 3.517 mln (was 3.499 mln) the previous week. Both were at post-pandemic lows but this was the first weekly gain since April. The initial claims data are for the BLS survey week containing the 12th of the month, while continuing claims are reported with a one week lag and so it will be the data next week that will be for the survey week. Of note, consensus for June NFP is currently at +750k vs. +559k in May.

EUROPE/MIDDLE EAST/AFRICA

U.K. reported very weak May retail sales. Headline sales were expected to rise 1.5% m/m but instead fell -1.4%. Likewise, sales ex-auto fuel were expected to rise 1.4% m/m but instead fell -2.1%. However, it is worth noting that these drops pale in comparison to the more than 9.0% gains posted by both series in April. Data suggest much of the fall was due to a shift from buying food to cook at home to eating out more as restrictions were lifted. Food sales fell a record -5.7%, while non-food sales climbed 2.3%.

U.K. infections are rising. Daily new cases have risen to around 11k, the highest since mid-February despite the nation’s aggressive vaccine roll-out. With new variants spreading even as restrictions have been lifted, the numbers would seem to justify the government’s recent decision to extend the last phase of restrictions into July. That said, the weak retail sales readings will certainly lead to some angst and second-guessing of the extension. Either way, these recent developments have dented some of the recent optimism on the U.K. recovery. Sterling traded today at the lowest level since early May near $1.3855, just above the May 3 low near $1.38.

The lira is outperforming on the day but is still net weaker in the aftermath of the FOMC and the CBRT meetings. The Turkish central bank left rates unchanged at 19.0% yesterday, with the statement retaining the hawkish language but not providing any hints of a change in stance. The odds of a hike are very slim given the political pressure, and it would take a major shock for it to happen (i.e. strong lira weakness). The path of least resistance is for a gradual easing later this year. This will put the CBRT against the tide of many EMs, dramatically increasing the risk of a policy mistake. Indeed, Erdogan has already staked out a rate cut in July or August, making for tense times ahead of the next meeting July 14.

ASIA

Bank of Japan kept policy unchanged, as expected. Of note, the bank said it will extend its emergency lending programs beyond September. It also announced that it will follow other central banks in encouraging green policies throughout the economy. The BOJ said the new initiative will aim to boost private-sector efforts to respond to global warming by providing cheap funds for bank lending to climate-friendly businesses. The bank said it would provide more details next month and launch it later in the year.

Ahead of the decision, May national CPI was reported. Headline inflation came in at -0.1% y/y vs. -0.2% and -0.4% in April, while core (ex-fresh food) rose 0.1% y/y vs. flat expected and -0.1% y/y in April. The core reading was the first positive one and the highest since March 2020. At the previous decision April 27, the bank unveiled new forecasts. The bank sees targeted core inflation at 0.1% (0.5% previously) for FY2021, 0.8% (0.7% previously) for FY2022, and 1.0% for FY23, which was added to the forecast horizon. The bottom line is that inflation is likely to remain below the 2% target through FY23 and so the BOJ has signaled that it intends to keep policy accommodative until FY24 at least. Updated forecasts will be released at the July 15-16 meeting.

The Reserve Bank of Australia estimates that QE has reduced yields on longer-term bonds by about 30 bp. According to an initial assessment, the RBA also estimates that QE has also lowered the spread on state and territory bond yields by 5-10 bp. It noted that “The bond purchase program has not had any substantial negative impact on the functioning of government bond markets.” The timing of the report is certainly interesting, coming just weeks ahead of its July 6 meeting, when the RBA will decide whether to extend QE or not. We believe the RBA will extend the program at its current pace but move to a more flexible QE program subject to more frequent reviews. This would set the table for likely tapering in H2 if the labor market continues to heal. Of note, a noted RBA-watcher from Down Under is now calling for lift-off in early Q1 23.

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