Dollar Soft Ahead of FOMC Decision

July 27, 2022

Win Thin

The Fed is widely expected to hike rates 75 bp to 2.50%; the press conference will be key; we think markets are setting themselves up for disappointment; the U.S. rates market continues to price in doom and gloom ahead of the FOMC decision
Reports suggest Russia is likely to continue limiting natural gas shipments to Europe; markets are still repricing ECB tightening; German GfK consumer confidence was reported for August; the U.K. race for Tory leadership is sharpening up
Australia reported mixed Q2 CPI data

The dollar is softer ahead of the FOMC decision. The dollar tends to weaken on FOMC decision days. DXY has fallen the past 3 meetings and 6 of the past 7. Similarly, the S&P 500 has risen the past 3 meetings and 6 of the past 7. DXY is trading back below 107. Despite the ECB’s hawkish surprise last week, the euro remains heavy as headwinds grow. Eurozone growth risks have risen sharply as Russia is likely to continue limiting its natural gas shipments (see below), which will make it difficult for the ECB to hike aggressively. USD/JPY is creeping higher to trade near 136.75, up from last week’s low near 135.55 but still well below last week’s high near 138.90. Sterling is trading back above $1.20 as it tries again to make a clean break above $1.21. We are not yet ready to change our strong dollar call, especially if the Fed delivers a hawkish message as we expect (see below). Yes, the U.S. economic data have been weakening but we do not think a recession is imminent. When all is said and done, we believe the U.S. economy remains the most resilient. However, we expect a period of consolidation ahead for the dollar until the U.S. economic outlook becomes clearer.

AMERICAS

The two-day FOMC ends today and the Fed is widely expected to hike rates 75 bp to 2.50%. WIRP suggests only 10% odds of a 100 bp move. Updated macro forecasts and Dot Plots won’t come until the September meeting. Another 75 bp hike September 21 is only about 45% priced in, with a 50 bp move favored then. A 25 bp hike is priced in for November 2 but after that, one last 25 bp hike is only partially priced in. The swaps market paints a similar picture, with 175 of tightening priced in over the next 6 months that would see the policy rate peak near 3.5%. Then, an easing cycle is priced in for the subsequent 6 months. This pricing is now more dovish than the June Dot Plots, which sees the Fed Funds rate rising to 3.75% in 2023 before falling to 3.375% in 2024.

The press conference will be key. Chair Powell will undoubtedly be pressed on how the Fed views the recent weak data and whether it will impact the Fed’s decision-making going forward. He will also be pressed to validate market expectations for a peak Fed Funds of 3.5% followed by rate cuts in H1 2023. Powell will surely be asked about the U.S. yield curve, which is moving closer to inversion. We believe Powell will maintain the Fed’s focus on lowering inflation; indeed, he can point to the slowing economy as proof that the Fed’s policies are working and point to still-high inflation as proof that more work needs to be done.

As a result, we think markets are setting themselves up for disappointment. The Fed is likely to stick to its hawkish tone and simply won’t entertain any notions of eventual easing at this juncture. Think about it: the Fed has only hiked three times for a total of 150 bp and is not even halfway to what it sees as the terminal rate. Why would it pivot away from its hawkish message now? The Fed cannot acknowledge that a recession is coming, as much as the markets are punching the panic button. The missing piece of the puzzle is where inflation stands if and when the recession hits. Can the Fed cut rates if inflation is still running well above target? When does the Fed pivot from its inflation focus to put more weight on full employment? No one has the answers to these questions, not even the Fed. As such, we take issue with the swaps market pricing in a 3.5% peak Fed Funds over the next 6 months followed by an easing cycle over the subsequent 6 months. We suspect inflation will remain sticky and the Fed will not reverse course so quickly even if the economy slows too rapidly. Lastly, there will be no Fed Put. Period.

After this FOMC meeting, the next big Fed event will be its Jackson Hole Economic Symposium next month. It is scheduled for August 25-27 and this year’s theme is "Reassessing Constraints on the Economy and Policy." Fed Chairs often use this symposium in August to announce or hint at policy shifts ahead of the September FOMC meetings. By late August, we will have seen all the major July data and some of the early August surveys such as the preliminary S&P Global PMI readings and regional Fed surveys. The Fed will also have a good idea of how the economy is doing in Q3. That said, we do not think the Fed will paint itself into a corner ahead of the September 20-21 FOMC meeting. Rather, we expect the Fed to try and manage market expectations at Jackson Hole. Much will depend on how markets digest today’s decision. Stay tuned.

The U.S. rates market continues to price in doom and gloom ahead of the FOMC decision. The 10-year yield traded as low as 2.70% yesterday but rebounded to trade near 2.80% currently, while the 2-year yield traded as low as 2.97% yesterday but rebounded to trade near 3.05% currently. As a result, the 2- to 10-year curve moved further into inversion at -26 bp. The 3-month to 10-year remains positively sloped but at 30 bp, it is the flattest since March 2020. If the Fed delivers a hawkish message today, we fear that this curve will move closer to inversion.

Regional Fed manufacturing surveys for July continue rolling out. Yesterday, Richmond Fed came in at 0 vs. -14 expected and a revised -9 (was -11) in June. Before that, Dallas Fed came in at -22.6 vs. -17.7 in June, Philly Fed came in at -12.3 vs. -3.3 in June, and the Empire survey came in at 11.1 vs. -1.2 in June. Kansas City wraps things up Thursday and is expected at 3 vs. 12 in June. 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. ISM PMI readings are given more weight by the markets and will be reported next week. Obviously, there are clear downside risks to those readings.

Minor U.S. data will be reported today. June advance goods (-$103.0 bln expected), wholesale and retail inventories, durable goods orders (-0.4% m/m expected), and pending home sales (-1.0% m/m expected) will be reported. Of note, the housing data continue to weaken. Yesterday, June new homes came in at -8.1% m/m vs. -5.9% expected and a revised 6.3% (was 10.7%) in May. This dragged the y/y rate down to -17.4% vs. -13.2% in May. We expect weakness in this sector to continue but this is what the Fed is aiming to do.

EUROPE/MIDDLE EAST/AFRICA

Reports suggest Russia is likely to continue limiting natural gas shipments to Europe as long as the sanctions from Ukraine remain in place. Unnamed sources were cited but this really should come as no surprise. Publicly, Russia claims that technical issues and sanctions-related delays to regular maintenance have forced it to cut supplies in recent weeks. Privately, sources say Russia is using the supply disruptions in Nord Stream to keep pressure on Western Europe to eventually drop sanctions. These sources expect Kremlin leadership and Gazprom to keep finding reasons to keep gas flows limited, which in turn would prevent European importers from building up stockpiles ahead of the winter. EU officials are already warning of major economic disruptions if flows don’t resume and are coming up with plans to cut consumption by 15%.

Markets are still repricing ECB tightening. WIRP suggests 50 bp hikes are no longer priced in for the next meetings September 8 and October 27. Looking ahead, the swaps market is pricing in 175 bp of tightening over the next 12 months that would see the deposit rate peak near 1.75%, down from 2.0% last week. As the data have weakened, so too has the perceive ability of the ECB to tighten. The worsening natural gas situation makes things worse.

German GfK consumer confidence was reported for August. It came in at -30.6 vs. -28.9 expected and a revised -27.7 (was -27.4) in July. This was the lowest on record dating back to 1991. GfK official said "In addition to concerns about interrupted supply chains, the Ukraine war and sharply rising energy and food prices, there are now fears about sufficient gas supplies for the economy and private households next winter.” Earlier this week, July IFO business tumbled to 88.6 vs. 92.2 in June, the lowest since June 2020, and comes after the composite PMI fell below 50 in July. Simply put, German is tipping into recession and the headwinds are only growing. GfK added "Fears of an impending recession are rising among consumers.”

The race for Tory leadership is sharpening up. As we expected, the policy divide between Sunak and Truss is mostly along the lines of tax cuts. For now, it appears both are more focused on difficult domestic conditions as Brexit moves to the back burner for now. Former Chancellor Sunak is sticking to his long-held stance of fiscal responsibility, while Truss is pledging immediate tax cuts to boost the economy. Of course, a big injection of fiscal stimulus may not be the best idea when headline inflation is running at 9.4% as it could require an even greater monetary policy response from the BOE than what would ordinarily be needed. However, Truss is leading in most polls and so Sunak just pledged to scrap the VAT on all domestic energy bills next year if he were to lead the next government. This an about-face that is basically driven by the political realities.

ASIA

Australia reported mixed Q2 CPI data. Headline came in at 6.1% y/y vs. 6.3% expected and 5.1% in Q1, while trimmed mean came in at 4.9% y/y vs. 4.7% expected and 3.7% in Q1. Despite the modest downside miss, headline is still the highest since Q2 2001 and further above the 2-3% target range. The RBA meets next week. WIRP suggests 50 bp hikes August 2 and September 6 are no longer fully priced in, with odds around 75% for both. Similarly, 50 bp hikes are only about 50% priced in for both October 4 and November 1. While the urgency to hike big has eased, the swaps market is still pricing in 225 bp of tightening over the next 12 months that would see the policy rate peak near 3.6%, steady from the start of this week but down from nearly 4.5% that was priced in at the start of this month. If the economy continues to weaken, markets will have to reassess this expected terminal rate. June retail sales will be reported tomorrow and are expected to rise 0.5% m/m vs. 0.9% in May. Q2 PPI and June private sector credit data will be reported Friday.

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