Dollar Soft Ahead of Jobs Report

August 02, 2024

Win Thin

The market is once again getting carried away with Fed easing expectations; U.S. yields continue to fall; highlight will be the July jobs report; Colombia central bank releases its quarterly inflation report
BOE started the easing cycle with a 25 bp cut to 5.0%; BOE July DMP inflation expectations continue to fall; eurozone countries reported soft June data; Switzerland reported July CPI and PMIs
Japan stocks saw the biggest two-day drop since the 2011 tsunami; Australia reported Q2 PPI; Korea reported July CPI

The dollar is trading soft ahead of the jobs report. DXY is trading lower near 104.120 as UST yields drop on growing concerns that the Fed is behind the curve. We disagree (see below). The yen is outperforming and up for the fourth straight day. It remains below 149 and this is taking a huge toll on Japan equities (see below). Sterling is trading flat near $1.2740 in the wake of the BOE cut (see below), while the euro is trading higher near $1.0820 despite soft economic data (see below). While the Fed is expected to cut rates in September, we think markets are overreacting to recent softness in the U.S. data. Looking at the totality of the data, the economy is still growing above trend and suggests the market is once again getting carried away with its pricing for aggressive easing (see below). We continue to believe that the divergence story remains in place and should continue to support the dollar.

AMERICAS

The market is once again getting carried away with Fed easing expectations. Three cuts are fully priced in by year-end, with nearly 50% odds of a fourth. There are also nearly 35% odds that the first cut in September will be 50 bp. Looking further out, the market is now pricing in 175 bp of total easing over the next 12 months. This is clearly an overreaction to the Fed’s dovish hold, coupled with some softness in the economic data. Despite growing concerns that the Fed is behind the curve and reacting too slowly to early signs of softer U.S. economic activity, we are more constructive on the outlook. As such, we continue to believe that the Fed will cut in September but will not cut as aggressively as market pricing.

U.S. yields continue to fall. The 10-year yield has fallen to 3.93%, the lowest since February, while the 2-year yield has fallen to 4.11%, the lowest since January. Lower yields would tend to loosen financial conditions, but this has been offset by falling equity markets. We’re not sure how this will net out when this week’s financial conditions are reported next Wednesday by the Chicago Fed. However, we remain confident that financial conditions are likely to continue loosening in the run-up to the first cut in September and then beyond.

Highlight will be the July jobs report. Bloomberg consensus sees 175k vs. 206k in June, while its whisper number stands at 170k. For reference, the average non-farm payrolls monthly gain over the past 12 months is 220k. ADP headline was 122k, but we note that NFP has outperformed ADP two straight months and 10 of the past 11. The unemployment rate is expected to remain steady at 4.1%, while average hourly earnings are expected to fall two ticks to 3.7% y/y.

The U.S. economy remains robust. The Atlanta Fed’s GDPNow model is now tracking Q3 growth at 2.5% SAAR and will be updated next Tuesday after the data. Elsewhere, the New York Fed’s Nowcast model is tracking Q3 growth at 2.7% SAAR and will be updated later today. Its initial estimate for Q4 growth will come at the end of August. Either way you slice it, the US economy continues to grow above trend, and that means the Fed won’t have to cut rates aggressively.

July ISM manufacturing PMI was soft. Headline came in at 46.8 vs. 48.8 expected and 48.5 in June and was the weakest since November. The details were similarly weak, with production at 45.9 vs. 48.5 in June, new orders at 47.4 vs. 49.3 in June, and employment at 43.4 vs. 49.3 in June. Prices paid came in at 52.9 vs. 52.1 in June.

Colombia central bank releases its quarterly inflation report. Updated forecasts are likely to justify continued easing. The bank just cut rates 50 bp to 10.75%. The vote was 5-2, with the two dissents in favor of a larger 75 bp cut. The market is pricing in 275 bp of total easing over the next 12 months.

EUROPE/MIDDLE EAST/AFRICA

Bank of England started the easing cycle with a 25 bp cut to 5.0%. However, we believe the bar for an aggressive BOE easing cycle is high. First, the decision to cut was a close call. The vote split was 5-4, with the 4 dissents supporting the case for no cut. Second, the BOE warned that “monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term had dissipated further.” Third, updated macro projections see stronger GDP growth, flat unemployment, and a moderate rise in inflation in the second half of this year. Indeed, the BOE cautioned “there is a risk that inflationary pressures from second-round effects will prove more enduring in the medium term.”

U.K. easing expectations have intensified. After the BOE decision, the swaps market sees the policy rate falling to 3.75% over the next 12 months vs. 4.0% ahead of the decision. This is taking a toll on sterling, which traded today at the lowest since early July and is on track to test the June 27 low near $1.2615. It's still top major performer YTD but the sheen seems to be wearing off as the BOE easing cycle gets under way.

July DMP inflation expectations continue to fall. Both 1- and 3-year expectations fell to 2.5% in July, the lowest since this series began in 2022. If sustained, this drop in inflation expectations should give the BOE more confidence to continue cutting rates.

Eurozone countries reported soft June data. French IP came in at -1.6% y/y vs. -1.1% expected and -3.1% in May, Italian IP came in at -2.6% y/y vs. -3.3% in May, and Italian retail sales came in at -1.0% y/y vs. a revised 0.5% (was 0.4%) in May. Eurozone retail sales won’t be reported until next Tuesday and IP won’t be reported until August 14. ECB easing expectations have picked up, as markets are beginning to price in nearly 65% odds of a third cut by year-end.

Switzerland reported July CPI. Headline remained steady at 1.3% y/y and core remained steady at 1.1% y/y, both as expected. The SNB has scope to ease further as inflation is tracking below its Q3 projection of 1.5% and remains well within the bank’s stability range of 0-2%. The swaps market is pricing in 90% odds of a third straight rate cut to 1.00% in September and will remain a drag on CHF.

Switzerland also reported soft July PMIs. Manufacturing came in at 43.5 vs. 44.5 expected and 43.9 in June, while services came in at 44.7 vs. 52.0 in June. Both are below 50 again and points to softer hard data ahead.

ASIA

Japan stocks saw the biggest two-day drop since the 2011 tsunami. The Topix fell -6.1% today after losing -3.2% yesterday, while the Nikkei 225 fell -5.8% today after losing -2.5% yesterday. While the root of the problem is the strong yen, there have also been growing risk off impulses due to concerns about the global growth outlook. Markets are left wondering whether the broader economy can withstand the shock of a strong yen as even before this week’s developments, Japan economic data had been softening.

Australia reported Q2 PPI. PPI rose 4.8% y/y vs. 4.3% in Q1. It has accelerated for three straight quarters to the highest since Q1 2023 and will keep the RBA on alert. The big question is whether firms can pass on higher input costs to the consumer. Given recent weakness in retail sales, the pass-through will likely be limited, which would put the RBA more at ease. The market seems to agree and sees over 80% odds of a cut by year-end.

Korea reported July CPI. Headline came in a tick higher than expected at 2.6% y/y vs. 2.4% in June, while core came in a tick higher than expected at 2.2% y/y and was unchanged from June. This was the first acceleration in headline inflation since February and remains above the 2% target. At the last meeting July 11, Bank of Korea delivered a dovish hold. It kept rates steady at 3.5%, as expected, but said that it would consider rate cut timing while assessing the outlook for inflation and financial stability. The decision was unanimous, but Governor Rhee said that excluding him, four BOK members saw steady rates over the next three months and two were open to a rate cut during that same period. The next meeting is August 22 and seems too soon for a cut given the acceleration in inflation. The market still sees steady rates over the next three months, followed by 25 bp of easing over the subsequent three months.

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