Dollar Soft Despite the Return of Risk Off Impulses

July 08, 2021
  • The strong flattening trend in the U.S. yield curve that stated in mid-May has accelerated; FOMC minutes were released; some minor data will be reported; Mexico reports June CPI; Peru is expected to keep rates steady at 0.25%
  • ECB will announce the results of its strategy review; it also releases its account of the June 10 meeting; Poland is expected to keep rates steady at 0.10%; Russia June CPI data surprised to the upside again
  • Tokyo was put under its fourth state of emergency as virus numbers jump; Japan reported May current account data; China’s fixed income markets are following the global trend as the PBOC pledged more policy support; Malaysia’s political outlook just got a lot more complicated as the ruling coalition splinters

The downdraft in global yields has accelerated. U.S. 10-year yield is now below 1.30%, not helped by the Fed’s message yesterday that tapering may come “somewhat earlier” than previously thought, which has a flattening effect. The ECB will likely put itself deeper in the dovish camp with its about to be announced strategy review (see below). But in the end, we suspect that a bit part of the decline in back-end yields comes from reduced growth expectations as the delta variant takes sets back the optimistic trajectory for economic normalization.

FX markets are showing a distinct risk-off flavor today. The yen and Swiss franc are the best major performers, suggesting they still hold a bit of safe haven status. EM FX is mostly weaker, but the dollar’s performance is a bit puzzling. We would expect the greenback to also benefit from risk off trading, and yet DXY is down modestly on the day. For now, we expect dollar strength to reassert itself, due both to its haven status and also to the expected economic outperformance of the U.S. economy.


The strong flattening trend in the U.S. yield curve that stated in mid-May has accelerated. And this is a global phenomenon as the growing negative virus news stream is helping to push yields down everywhere. While we have been focusing very much on the domestic story for U.S. yields, it’s clear that this cannot be done in isolation and so global drivers are taking the lead now. As always, we remain very bullish on the U.S. economy but the virus numbers have clearly worsened for a large portion of the world. The fact that China is moving towards adding more stimulus (see below) may have been the final wakeup call, as the world’s second largest economy struggles to mount a durable recovery. This week’s risk off backdrop is the first in recent memory. How long and how deep remains an open question but there is no doubt that investors have turned more negative from the virus news stream.

FOMC minutes were released. Fed officials expected progress in meeting the tapering threshold would continue. Some saw the conditions for tapering being met sooner than they had anticipated at previous meetings, while others felt that incoming data were providing a less clear signal about the economy and thought it prudent to wait for more information in the coming months. Several favored tapering MBS faster than UST. The bottom line is that some are pushing for tapering sooner rather than later and some are counseling patience. With this split in place, it seems tapering is not likely to be imminent. While we expect the debate to continue and intensify at the July 27-28 meeting, we don't think the Fed will commit to tapering yet. That said, we still think the Fed tapers before year-end and may provide more clarity at the August Jackson Hole Symposium or the September 21-22 FOMC meeting.

Some minor data will be reported. Jobless claims are expected to show improvement, with initial claims seen falling to 350k from 364k the previous week and continuing claims seen falling to 3.335 mln from 3.469 mln the previous week. If so, this would be continued improvement in the labor market. May JOLTS data yesterday showed job openings rose to a marginal all-time high of 9.209 mln, slightly less than the expected 9.325 mln. The data support the notion that recent softness in the jobs numbers is due largely to supply, not demand. May consumer credit will also be reported and is expected at $18.0 bln vs. $18.612 bln in April.

Mexico reports June CPI. Headline inflation is expected to ease to 5.87% y/y from 5.89% in May. if so, it would be the second straight month of deceleration but still well above the 2-4% target range. Banco de Mexico will also release its minutes. At the June 24 meeting, it delivered a surprise 25 bp rate hike to 4.25%. The decision was agreed by only three of the five members, so it was a close call. Banxico’s base case is still for current inflation pressures to prove transitory, meaning that we probably shouldn’t expect a protracted tightening cycle, not even close to what we will get in Brazil for example. Next policy meeting is August 12.

Peru central bank is expected to keep rates steady at 0.25%. At the last meeting June 10, it kept rates on hold without any major changes in its guidance. Headline inflation rose to 3.25% in June vs. 2.45% in May, the highest since April 2017 and above the 1-3% target range. The bank is keeping to the line of transitory inflation risks to justify its dovish bias, even keeping the possibility of additional stimulus on the table, though we doubt it will be necessary. Of note, Governor Velarde will reportedly speak about his future role with President-elect Castillo once he has been declared the winner.


The ECB will announce the results of its strategy review today. A press conference will be held with ECP President Lagarde shortly thereafter. We think markets have priced in some sort of tweak to the inflation target from the current “below, but closer to, 2%.” While some sort of overshoot of 2% may be allowed, this would fall short of average inflation targeting that explicitly calls for inflation to be allowed to run hot. Hawks like Weidmann have reportedly pushed for a symmetric target around 2% but that's not as powerful or as dovish as AIT. As always, the Fed has opened the door first and provided other central banks with the blueprints for a new type of monetary policy framework. First it was QE, now its AIT. Either way, we believe markets have largely priced in some weakened form of AIT and so anything that falls short would likely lead to knee-jerk euro buying.

The ECB releases its account of the June 10 meeting. Rates were kept steady then and the bank promised to maintain a “significantly higher” pace of purchases that was first announced at the March meeting. Growth and inflation forecasts were upgraded. Of note, the ECB forecast 2021 inflation at 1.9% vs. 1.5% in March, 2022 inflation at 1.5% vs. 1.2% in March, and 2023 inflation at 1.4% vs. 1.4% in March. As Madame Lagarde pointed out, inflation is seen below target for the entire forecast horizon, which of course implies no rate hikes before 2024. The account should help markets assess how strong the resistance was to extend the higher pace of purchases. For now, the doves have the upper hand.

National Bank of Poland is expected to keep rates steady at 0.10%. Minutes for the June 9 meeting will be released Friday. CPI inflation eased to 4.4% y/y in June vs. 4.6% expected and 4.7% in May. This was the first deceleration since February and gives the central bank some breathing room as it fits the narrative that the spike in inflation is transitory. The bank has been coming under pressure to tighten, but Governor Glapinski continues to push back against making an “hasty” moves. He also favors a weaker zloty, noting that FX intervention aimed at weakening the currency helped the economy recover from the pandemic and added that this tool should be used by all EM policymakers.

Russia June CPI data surprised to the upside again, ensuring the central bank will retain its hawkish stance and possibly accelerate hikes. Headline inflation came in at 6.5% y/y, slightly higher than expected but well above the 6% reading in the previous month and well off the 4% target. Yet the real surprise came from the core measure rising from 6.0% y/y to 6.6%, as well as accelerating inflation in the services sector. The bank started tightening in March with an unexpected 25 bp hike, then surprised again in April by increasing the size to 50 bp, then delivered the expected 50 bp hike in June. We think the odds of another acceleration to 75 bp at the July 23 meeting is now very high, and will soon be priced in by investors. Current consensus is 50 bp.


Tokyo was put under its fourth state of emergency as virus numbers jump. It will be effective July 12 and remain in place until August 22, which would take it through the end of the Olympics. Tokyo accounts for around a fifth of Japan’s GDP and so the move has serious implications for the national outlook. Indeed, senior LDP official Nikai called for another stimulus package worth around JPY30 bln ($273 bln) as the growth outlook worsens for Q3. We have long called for such a package and all signs point to a go. Speaking of the Olympics, reports suggest all spectators will be banned and so there is not going to be much of a positive bump to the economy.

Japan reported May current account data. The adjusted surplus was larger than expected, rising to JPY1.866 trln from JPY1.552 trln in April. However, the investment flows will be of most interest. In May, Japanese investors sold foreign bonds after massive purchases in April to kick off the new fiscal year. MOF data show net sales of JPY496 bln of U.S. sovereign bonds in May vs. JPY1.7 trln of purchases in April. It appears that some sort of rotation trade was under way, as Japanese investors bought a net JPY293.9 bln of U.S. equities in May after selling JPY1.63 trln April, the most ever in data going back to 2005. Japanese investors also net sold Canadian and Australian sovereign debt in the amounts of JPY18.5 bln and JPY61.5 bln, respectively. Italian bonds were also sold to the tune of JPY44.2 bln.

China’s fixed income markets are following the global trend as the PBOC pledged more policy support. The local 10-year yield is down 4 bp to 3.0%, the lowest levels since last August. Policymakers in the State Council signaled they would like to see stronger bank lending, which will likely happen via a cut in the required reserve ratio (RRR). While not confirmed, this is an important signal that goes against our previous base case of a tightening bias, even if it wouldn’t be manifested any time soon. We've seen this play out time and time again, where China policymakers pledge to stop relying on credit fueled growth, only to reverse themselves after the economy slows more than expected. The yuan is 0.1% weaker on the day, not out of line with the broader moves, but this policy signal could also mean greater tolerance towards a weaker currency as the global demand falters under the delta variant.

Malaysia’s political outlook just got a lot more complicated as the ruling coalition splinters. Prime Minister Muhyiddin Yassin lost support of his largest coalition member UMNO, meaning that new elections might be coming soon. That said, it’s unclear whether he will step down and if Malaysia can reasonably have an election in middle of the pandemic. The official justification by the UMNO was the PM’s mismanagement of the pandemic and failing to deliver on the economic front. Muhyiddin agreed to convene parliament (suspended since January) for five days starting July 26 and so the political outlook could clear up a bit then. Separately, the central bank kept rates on hold at 1.75%, as expected. The risk is for the “significant downside risks” to tip policymakers towards easing in the next few meetings. Malaysia returned to a hard lockdown June 1 and so there were headwinds to the economy in Q2 that may be spilling over into Q3. MYR depreciated 0.5% today and the local KLCI equity index fell 1.4%, neither too far from the broad risk-off moves across the region.

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