Dollar Remains Under Pressure

July 29, 2022

Win Thin

We got our first look at Q2 GDP and it wasn’t pretty; the GDP data means absolutely nothing with regards to Fed policy; June core PCE data will be important; July Chicago PMI will also be closely watched; Colombia is expected to hike rates 150 bp to 9.0%.
July eurozone CPI readings came in very hot; Q2 eurozone GDP data came in stronger than expected; ECB tightening expectations continue to adjust
July Tokyo CPI was reported; BOJ board members remain worried about downside risks; given the long-standing monetary policy divergence, we can only explain the recent yen strength as a positioning washout; Australia reported Q2 PPI and June private sector credit data; China reports official July PMI readings Saturday local time

The dollar remains under pressure as the week draws to a close. DXY is down for the third straight day and trading at new lows for this move near 105.830, moving below 106 for the first time since July 5. The yen is leading this move, with USD/JPY trading as low as 132.50 today before recovering to trade near 133.25 currently. The euro is inching above $1.02, helped by higher than expected CPI and stronger than expected GDP data (see below). Sterling traded as high as $1.2245 today before moving back below $1.22. We maintain our strong dollar call and believe that markets are misreading the Fed’s commitment to lowering inflation (see below). There was simply no pivot and no weakening in its resolve to lower inflation.

AMERICAS

Market expectations for Fed tightening continue to diverge. WIRP suggests a 50 bp hike September 21 is fully priced in, with around 30% odds of a 75 bp move. Another 25 bp hike November 2 fully priced in but after that, one last 25 bp hike December 14 is only about 70% priced in that would see a terminal rate near 3.5%. The swaps market paints a different picture, however, with 150 of tightening priced in over the next 6 months that would see the policy rate peak near 4.0%, up from 3.5% at the start of this week. It seems that these two markets heard vastly different messages from the Fed this week; we believe the more hawkish take by the swaps market is closer to the mark.

We got our first look at Q2 GDP and it wasn’t pretty. The economy contracted -0.9% SAAR vs. expected growth of 0.4% SAAR. While this means that the U.S. economy contracted two straight quarters, that does not mean it has entered recession. That will eventually be decided much later by the folks at the National Bureau of Economic Research. Note that the Atlanta Fed’s GDPNow model was tracking -1.2% SAAR in its final update and was closer to the mark than the analyst community was. This model’s initial Q3 estimate will be unveiled today. Of note, Bloomberg consensus for Q3 is currently 1.7% SAAR. Q2 employment cost index and final July University of Michigan consumer sentiment will also be reported today.

The GDP data means absolutely nothing with regards to Fed policy. When asked repeatedly about how a potential recession might impact Fed policy, Powell demurred and continued to put all emphasis on lowering inflation. Full stop. He stressed that the Fed wants to slow growth below potential in order to create more slack in the economy. If even slower growth (or recession) is needed to create that slack and move inflation back to target, we believe the Fed is willing to accept that as the cost of doing business. It’s not a preferred outcome, but it is acceptable.

The U.S. rates market continues to price in doom and gloom. The 10-year yield traded as low as 2.65% yesterday, the lowest since April 14, and has recovered to 2.70% currently. The 2-year yield traded as low as 2.81% yesterday, the lowest since July 6, and has recovered to 2.87% currently. This has led curve flattening to pause. The 2- to 10-year curve has risen to -17 bp from the cycle low near -25 bp earlier this week. Faithful readers know that we prefer to look at the 3-month to 10-year curve and flattening there has also paused. At 37 bp, it is up from the 33 bp cycle low earlier this week but remains concerning at such low levels.

June core PCE data will be important. It is expected to remain steady at 4.7% y/y after three straight months of deceleration from the 5.3% peak in February. Still, it is nowhere close to the Fed’s 2% target. While some measures of inflation have started to turn, the Fed is in no position to pivot more dovish. Personal income and spending will be reported at the same time and are expected at 0.5% m/m and 0.9% m/m, respectively. Real personal spending is expected flat m/m vs. -0.4% in May.

July Chicago PMI will also be closely watched. It is expected to fall a full point to 55.0. Last week, preliminary July S&P Global PMI readings for the U.S. came in much weaker than expected as the composite fell to 47.5, the lowest since May 2020 and drive mostly by a drop in services to 47.0. The more widely watched ISM PMI readings will be reported next week, with manufacturing Monday expected at 52.1 vs. 53.0 in June and services Wednesday expected at 53.9 vs. 55.3 in June. After the S&P Global readings, there are clear downside risks to the upcoming survey data. Of note, the regional Fed manufacturing surveys ended on a strong note yesterday as Kansas City came in at 13 vs. 4 expected and 12 in June. These July readings have been mixed.

Colombia central bank is expected to hike rates 150 bp to 9.0%. At the last meeting June 30, the bank hiked rates 150 bp to 7.5% and said the tightening cycle likely hasn’t ended. The swaps market is pricing in 350 bp of tightening over the next 6 months that would see the policy rate peak near 11.0%. CPI rose 9.67% y/y in June, the highest since June 2000 and further above the 2-4% target range. The economy remains robust and so the bank is likely to continue tightening in H2.

EUROPE/MIDDLE EAST/AFRICA

July eurozone CPI readings came in very hot. Germany reported yesterday and its EU Harmonized CPI came in at 8.5% y/y vs. 8.1% expected and 8.2% in June. France and Spain also came in higher than expected today, while Italy was slightly lower than expected. All in all, this led the eurozone headline come in at 8.9% y/y vs. 8.7% expected and 8.6% in June. Elsewhere, core inflation came in at 4.0% y/y vs. 3.9% expected and 3,7% in June. Both readings were new record highs and will maintain pressure on the ECB to tighten even as headwinds to growth build.

Q2 eurozone GDP data came in stronger than expected. Q/q growth came in at 0.7% vs. 0.2% expected and a revised 0.5% (was 0.6%) in Q1, while y/y growth came in at 4.0% vs. 3.4% expected and 5.4% in Q1. This is one of those rare instances where the eurozone outperforms the U.S. in terms of growth. As expected, Germany was the weak link and stagnated q/q, while the other major economies outperformed expectations. France grew 0.5% q/q, Italy grew 1.0% q/q, and Spain grew 1.1% q/q. The preliminary July PMI readings last week suggest Germany is already tipping into recession and the real sector data bear that out. Of note, Germany and Italy are most vulnerable to a shortage of energy shipments from Russia.

ECB tightening expectations continue to adjust. WIRP suggests 50 bp hikes are no longer fully priced in for the next ECB meetings September 8 and October 27. Looking ahead, the swaps market is now pricing in only 100-125 bp of tightening over the next 12 months that would see the deposit rate peak between 1.0-1.25% vs. 1.75% at the start of this week. This is a huge move and reflects the worsening economic outlook in Europe, especially Germany. Note that German unemployment jumped 48k in June vs. 17.0k expected. Retail sales, trade, factory orders, and IP will all be reported next week and are expected to show further weakness.

ASIA

July Tokyo CPI was reported. Headline came in at 2.5% y/y, core (ex-fresh food) came in at 2.3% y/y, and core ex-energy came in at 1.2% y/y. All three measures picked up two ticks from June vs. one expected and points to upside risks to the national readings. Yet it’s clear from last week’s Bank of Japan decision that it is in no hurry to exit its ultra-loose stance. Next policy meeting is September 22 and no change is expected then. The swaps market is basically pricing in steady policy for the next 36 months, with very small odds of liftoff seen towards the end of that period.

Bank of Japan board members remain worried about downside risks. The summary of last week’s policy meeting revealed that one member warned “Amid monetary tightening in Europe and the United States, it is necessary to pay attention to risks that could affect Japan’s economy, including that of the U.S. economy falling into recession.” Several members called for continued monetary easing in the absence of wage gains, while a couple felt that the bank should wait to make a decision on its special Covid funding program until September, when it is scheduled to end. Indeed, one board member said risks to the economy are on the downside due to the renewed rise in virus numbers, both domestically and globally. Recall that the BOJ cut its growth forecast for FY22 last week.

Given the long-standing monetary policy divergence, we can only explain the recent yen strength as a positioning washout. USD/JPY traded as low as 132.50 today and is on track to test the June 16 low near 131.50. Looking further out, a break below 131.35 would set up a test of the May 24 low near 126.35. This is a prime example of why Japan policymakers are reluctant to give any hint of normalizing policy; the yen could easily gain 10-20% on such news. As it is, USD/JPY has fallen nearly 5% from the July 14 peak near 139.40 with no change in the fundamental drivers.

Meanwhile, the real sector data were mixed. June labor market data, retail sales, and IP were reported. Unemployment unexpectedly remained steady at 2.6% even though the job-to-applicant ratio rose three ticks to 1.27. It’s worth recalling that Deputy Governor Amamiya just predicted greater wage pressures next fiscal year, as the data appear to be setting the table for greater labor demand. This may be reflected in June labor cash earnings data that will be reported next Friday. Retail sales came in at -1.4% m/m vs. 0.2% expected and a revised 0.7% (was 0.6%) in May, while IP came in at 8.9% m/m vs. 4.2% expected and -7.5% in May. Recent Japan data will be seen as vindication by the BOJ in terms of maintaining its loose policy stance; the economic outlook remains cloudy while inflation remains under control.

Australia reported Q2 PPI and June private sector credit data. PPI inflation picked up to 5.6% y/y vs. 4.9% in Q1, which suggests some upward pressure on CPI will still be seen in the coming quarters. Q2 CPI was reported earlier this week at 6.1% y/y vs. 6.3% expected and 5.1% in Q1, while the real sector data have been softening. The RBA meets next week and WIRP suggests a 50 bp hike is only about 75% priced in vs. 100% at the start of this week. Odds for 50 bp hikes further out have also fallen, with September 6 now around 55%. The swaps market is now pricing in 175 bp of tightening over the next 12 months that would see the policy rate peak near 3.10%, down from 3.60% at the start of this week and nearly 4.5% at the start of this month.

China reports official July PMI readings Saturday local time. Manufacturing is expected to rise a tick to 50.3, while non-manufacturing is expected to fall a full point to 53.7. If so, the composite PMI would likely fall close to a point from 54.1 in June. Caixin reports its PMI readings next week. For now, policymakers are using targeted stimulus efforts but if the economy continues to slow in H2, we expect more large-scale stimulus efforts to emerge.

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