Dollar Soft Despite Global Risk Rout

August 05, 2024

Win Thin

Market moves have quickly morphed into a global risk rout; we continue to believe that the market is once again overreacting to one data point; ISM services PMI will be the data highlight; the Fed’s SLOOS will be released; Colombia central bank minutes will be released
Eurozone reported final July services and composite PMIs; weak data should keep the ECB in easing mode; Turkey reported July CPI
Japan stocks have entered a bear market; minutes of the June BOJ meeting were released; Japan, Australia, and reported final July services and composite PMIs; Caixin reports soft July services and composite PMIs

The dollar is trading soft as global risk off impulses grow. DXY is trading lower for the second straight day near 102.640 as UST yields drop on growing concerns that the Fed is behind the curve. The yen and Swiss franc are outperforming as havens, but this has hurt the global carry trade as MXN and ZAR underperform. we expect the dollar smile to eventually come into play. Sterling is trading lower near $1.2755, and the euro is trading higher near $1.0940. 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. However, it will likely take weeks for the current market narrative to run its course.

AMERICAS

Market moves have quickly morphed into a global risk rout. It began as a logical response to last week’s BOJ hike and Fed cut, as the yen strengthened and the dollar weakened. However, the soft U.S. jobs data has raised fears that the Fed is behind the curve, and this has fed into a massive global bond rally and global equity selloff. Positioning and deleveraging have played a large role in these moves, especially in Japan equities (see below). The havens JPY and CHF have surged, which in turn has led to outsized losses in the global carry trade, with MXN and ZAR racking up huge losses.

We cannot stand in the way of this move. However, we believe fear has led markets to ignore the fundamentals. Recent data suggest that the U.S. is slowing but is not yet nearing recession. It will likely take weeks to get past this episode due to the lack of any top line U.S. data near-term. The dollar is starting the week off soft, but we expect the dollar smile to eventually come into play. The euro and sterling are not where one wants to be in a growing risk off environment.

We continue to believe that the market is once again overreacting to one data point. To wit, the market is fully pricing in 125 bp of easing by year-end, with the Fed’s first cut in September expected to be 50 bp. Looking further ahead, the market is pricing in 225 bp of total easing over the next 12 months. Unless the U.S. economy falls into a deep recession, this rate path seems very unlikely. Once must not forget that the market has been wrong about the Fed easing path this entire cycle.

We don’t think the Fed will be happy with this market narrative. If so, look for Fed speakers to push back in the coming days. Last Friday, Goolsbee stressed that “We’d never want to overreact to any one month’s numbers.” However, he reminded everyone that “if unemployment is going to go up higher than the neutral rate, that is exactly the kind of pinching on the other side of the mandate that the law says the Fed has to think about and respond to.” Goolsbee and Daly speak today. One last point to stress: there is no Fed put. If the U.S. economy weakens, it will cut rates. However, it will not respond to equity market losses. Period.

UST yields remain under downward pressure. The 10-year yield has fallen to 3.73%, the lowest since July 2023, while the 2-year yield has fallen to 3.75%, the lowest since May 2023. As a result, the 2- to 10-year is nearly flat at -2 bp; it has been inverted since July 2022. Lower yields tend to loosen financial conditions, but this was offset by falling equity markets. We’re not sure how this will net out when last week’s financial conditions are reported 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. Given the Fed’s concerns about the labor market, we think it will be happy to see the market do the easing for them even before it cuts.

ISM services PMI will be the data highlight. It has taken on much greater significance, as it will either reinforce or ease market concern that the Fed is behind the curve. Headline is expected at 51.0 vs. 48.8 in June. The already released regional Fed services business surveys point to downside risks. However, the US S&P Global services PMI rose to a 28-month high at 56.0 in July vs. 55.3 in June. Keep an eye on prices paid, activity, and employment.

The U.S. economy overall remains solid. Yes, there are pockets of weakness, but GDP grew 2.8% SAAR in Q2. For Q3, the Atlanta Fed’s GDPNow model is tracking 2.5% SAAR and will be updated Tuesday after the data. The New York Fed’s Nowcast model is tracking Q3 growth at 2.1% SAAR and will be updated Friday. Its first estimate for Q4 will come at the end of August.

The Fed’s Senior Loan Officer Opinion Survey will be released. The results will offer an overview of bank lending practices over Q3. We don’t expect any major surprises. The June FOMC meeting minutes pointed out that consumer credit remained generally available despite some signs of tightening. Credit also remained largely available to commercial real estate (CRE) borrowers outside of construction and land development loans.

Colombia central bank minutes will be released. At last week’s meeting, the bank cut rates 50 bp to 10.75%. The vote was 5-2, with the two dissents in favor of a larger 75 bp cut. Governor Villar tilted dovish, noting that inflation pressures have eased in recent months and that the risks related to a weak peso have dissipated. Villar added that the wider budget deficit doesn’t undercut monetary policy. The market is pricing in 325 bp of easing over the next 12 months.

EUROPE/MIDDLE EAST/AFRICA

Eurozone reported final July services and composite PMIs. Headline services was unchanged at 51.9 but the composite rose a tick from the preliminary to 50.2. Looking at the country breakdown, Germany’s composite rose four ticks from the preliminary to 49.1 and the French composite fell four ticks from the preliminary to 49.1. Spain and Italy report for the first time and their composite PMIs both came in weaker than expected and down from June at 53.4 and 50.3, respectively.

Weak data should keep the ECB in easing mode. Next meeting is September 12 and a 25 bp cut is fully priced in, with 25% odds of a larger 50 bp move. We think that 50 bp is unlikely, but it’s clear that the ECB will have to cut more than was expected back when it started the easing cycle in June. Indeed, the swaps market is pricing in over 75 bp of easing by year-end and 150 bp of total easing over the next 12 months.

Turkey reported July CPI. Headline came in at 61.78% y/y vs. 61.95% expected and 71.60% in June, while core came in at 60.23% y/y vs. 60.00% expected and 71.41% in June. Headline was the lowest since October but nowhere near the 3-7% target range. At the last meeting July 23, the central bank kept rates steady at 50.0% but said it would continue to mop up liquidity. The bank also warned that m/m inflation “will rise temporarily” in July and vowed to maintain tight policy until it sees a lasting slowdown in inflation. It added that “In addition to the high level of and the stickiness in services inflation, inflation expectations, geopolitical risks, and food prices keep inflationary pressures alive.” The market is pricing in the start of an easing cycle over the next three months. Next meeting is August 20, and no change is expected then. Central bank presents its quarterly inflation report Thursday.

ASIA

Japan stocks have entered a bear market. The Topix fell -12.2% today after losing -6.1% Friday and -3.2% Thursday, while the Nikkei 225 fell -12.4% today after -5.8% Friday and -2.5% Thursday. This was the biggest three-day rout since 1959, when the data series began, and both are down about 25% from their peaks in early July. While this selloff was triggered by the BOJ hike and the strong yen, there are growing risk off impulses globally and it’s clear that this move in Japan is being magnified by positioning and deleveraging.

Minutes of the June BOJ meeting were released. At that meeting, the bank kept rates steady but said it would pare its monthly bond-buying at the next meeting July 30-31. Board members said the bank should hike rates if the outlook for inflation and the economy matched its April forecasts. One board member said upside risks to inflation had become more noticeable and that the BOJ should be careful not hike rates too late. Some members felt that yen weakness was an upside risk to inflation, but one said that monetary policy should not be determined by short-term FX developments. The summary of opinions for the July 30-31 meeting will be released Thursday.

Japan reported final July services and composite PMIs. Services came in at 53.7 vs. 53.9 preliminary, while the composite came in at 52.5 vs. 52.6 preliminary.

Australia reported final July services and composite PMIs. Services came in at 50.4 vs. 50.8 preliminary, while the composite came in at 49.9 vs. 50.2 preliminary. This was the first composite reading below 50 since January. Meanwhile, the Melbourne Institute Monthly Inflation Gauge revealed that inflation re-entered the RBA’s 2-3% target band after falling to 2.8% in July from 3.2% in June. The RBA meets tomorrow and is expected to keep rates steady at 4.35%. We also anticipate the RBA to stick to its neutral policy guidance as Q2 inflation remained above the RBA’s 2-3% target and is largely tracking the RBA’s forecasts. The RBA will publish new sets of forecasts in its Statement on Monetary Policy.

Caixin reported July services and composite PMIs. Services came in at 52.1 vs. 51.5 expected and 51.2 in June, while the composite came in at 51.2 vs. 52.8 in June. This was the lowest Caixin composite since October. We believe the Caixin PMIs had been overstating growth in China but have eventually moved towards the weaker official readings that are likely closer to the mark.

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