Dollar Soft as Markets Digest China Developments

December 07, 2022

Win Thin

Markets are searching for direction as we await November PPI data Friday; Fed expectations have solidified after Powell’s speech last week; BOC is expected to hike rates 50 bp to 4.25%; Brazil is expected to keep rates steady at 13.75%; Peru is expected to hike rates 25 bp to 7.5%
Reports suggest that the ECB staff union is unhappy with planned wage hikes; eurozone countries reported some key data; Poland is expected to keep rates steady at 6.75%
BOJ board member Nakamura remains dovish; Australia reported Q3 GDP data; China continues to ease Covid restrictions; reports suggest China policymakers are debating a 2023 growth target near 5%; China reported soft November trade data; India hiked the repo rate 35 bp to 6.25%, as expected

The dollar is slightly weaker as markets digest more China reopening measures. DXY is trading slightly lower near 105.40 and needs to break above the 106 area to set up a test of last week’s high near 107.195. The euro is trading near $1.05 while sterling is trading near $1.2150. USD/JPY is trading at the highest level since December 1 near 137.65 and a clean break above 137.50 sets up a test of last week’s high near 140. While we still believe the fundamental outlook favors the dollar, we acknowledge that near-term dollar weakness is likely to persist after Powell’s unexpected dovish turn. If the U.S. data continue to come in firm like ISM services did, that dovish Fed narrative could start to crack ahead of next week’s FOMC meeting. Stay tuned.

AMERICAS

Markets are searching for direction as we await November PPI data Friday. The lack of any top tier data after Monday’s upside surprise to ISM services PMI has made it difficult for the dollar to build on its recent gains. So has the lack of any Fed speakers due to the media blackout. Today, only October consumer credit will be reported and it is expected at $28.0 bln vs.25.0 bln in September. Even news of further China reopening measures (see below) have not really budged markets today. One would expect higher equities and risk on trading but we’re not seeing that yet.

Fed expectations have solidified after Powell’s speech last week. WIRP suggests that a 50 bp hike December 14 is fully priced in, with only around 10% odds of a larger 75 bp move. The swaps market is pricing in a peak policy rate of 5.0%. What’s interesting is that WIRP suggests around 60% odds of a 50 bp move February 1 and then around 50% odds of a final 25 bp hike in Q2. With both AHE and core PCE flat-lining near 5% for most of this year, we don’t think this tightening path will get inflation back to target, not when the labor market remains so firm and consumption is holding up. This is where we believe the mispricing lies. If and when markets reprice, that should be dollar-positive.

Bank of Canada is expected to hike rates 50 bp to 4.25%. The analyst community is split between 25 and 50 bp, while WIRP suggests only 25% odds of a larger 50 bp move vs. 40% at the start of this week and 60% at the start of last week. We think going from 100 bp to 75 bp to 50 bp to 25 bp at consecutive meetings is too quick of a deceleration given how resilient the economy remains and so we favor a 50 bp hike. Furthermore, we don't think the BOC wants to deliver two dovish surprises in a row. It's a bad look when inflation is still raging. The swaps market is pricing in a peak policy rate near 4.25% vs. 4.25-4.5% at the start of last week. The Loonie tends to gain on BOC decision days. It has done so for the last three and for five of the past six, but so far is down today.

Brazil COPOM is expected to keep rates steady at 13.75%. At the last policy meeting October 26, it kept rates steady at 13.75%. However, the uncertain fiscal outlook has led markets to price in further tightening ahead. The swaps market is pricing in a peak policy rate near 14.5% over the next 6 months. November IPCA inflation will be reported Friday. Headline is expected at 6.05% y/y vs. 6.47% in October. If so, it would be the lowest since February 2021 and moves closer to the 2-5% target range. Of note, this range falls to 1.5-4.5% in 2023.

Peru central bank is expected to hike rates 25 bp to 7.5%. At the last policy meeting November 10, the bank hiked rates 25 bp to 7.25%. CPI rose 8.45% y/y in November vs. 8.28% in October, interrupting the decelerating trend from the 8.81% peak in June and further above the 1-3% target range. This argues for further tightening.

EUROPE/MIDDLE EAST/AFRICA

Reports suggest that the ECB staff union is unhappy with planned wage hikes. Specifically, the ECB’s trade union IPSO wants to amend the planned 4.07% salary increase that takes effect in 2023. This follows a mere 1.48% hike in 2022. IPSO official noted “With inflation in Germany and the euro area likely around 8.5% this year, it means a substantial loss in purchasing power.” He added that if real salaries continue to fall, “this is damaging workers morale and also their trust toward the institution.” Lastly, he warned that “If a negotiated approach to find a compromise continues to be rejected by the ECB, we will have to consider protest actions early next year.” The optics of that would be awful, to state the obvious.

ECB tightening expectations have solidified. WIRP suggests a 50 bp hike December 15 is fully priced in, with only 15% odds of a larger 75 bp move vs. 20% at the start of this week, 45% at the start of last week, and fully priced in right after the October decision. Elsewhere, the swaps market is still pricing in a peak policy rate near 3.0% vs. 3.5-3.75% right after the October decision. We think there is still room for ECB tightening expectations to fall further and we stand by our call that the ECB will pivot and cut rates before the Fed does. Lane and Panetta speak today.

Eurozone countries reported some key data. Germany reported October IP at -0.1% m/m vs. -0.6% expected and a revised 1.1% (was 0.6%) in September, while the y/y rate came in flat vs. -0.7% expected and a revised 3.1% (was 2.6%) in September. This follows better than expected factory orders data yesterday. Elsewhere, Italy reported October retail sales that were a tick better than expected at -0.4% m/m vs. 0.5% in September.

National Bank of Poland is expected to keep rates steady at 6.75%. Minutes to the November 9 meeting will be released Friday. At that meeting, it delivered a dovish surprise and kept rates steady vs. an expected 25 bp hike. Governor Glapinski said then that the tightening cycle was still on pause and had not ended. The swaps market is pricing in the start of an easing cycle within the next 3 months, which seems too soon.

ASIA

Bank of Japan Board Member Nakamura remains dovish. He said the bank needs to continue with monetary easing as the economy is still recovering from the pandemic. Nakamura also says inflation is not being caused by wage gains, something that policymakers have focused on this year. He warned that tightening monetary policy could bring back deflation as the economy still has a negative output gap. Lastly, Nakamura said that is not yet time for a BOJ policy review. These comments are consistent with Kuroda’s earlier this week and support our view that the BOJ is on hold for the time being. Next policy meeting is December 19-20 and no change is expected then.

Australia reported Q3 GDP data. Growth came in a tick lower than expected at 0.6% q/q vs. 0.9% in Q2, while the y/y rate came in at 5.9% vs. 6.3% expected and a revised 3.2% (was 3.6%) in Q2. The y/y gain was driven largely by low base effects from Q3 2021 and this should reverse in Q4 due to high base effects. That said, the RBA is likely to continue tightening after this week’s 25 bp hike. WIRP suggests 45% odds of a 25 bp hike February 7 while the swaps market is pricing in a peak policy rate near 4.0%, up from 3.55% at the start of this week. Updated forecasts will come at that February meeting.

China continues to ease Covid restrictions. Ten new rules were announced, including less emphasis on specifying high risk areas, reducing the frequency of mass testing, allowing home quarantine instead of government facilities, accelerating vaccinations for the elderly, and forbidding the blockage of emergency exits and apartment entrances. This last one is obviously in response to the deadly apartment fire last week that triggered the wave of protests. We admit to being surprised that authorities are backing down so quickly in the face of popular discontent. The big unknown is how badly the virus numbers jump and whether policymakers will walk back any of these looser measures. Stay tuned.

Reports suggest China policymakers are debating a 2023 growth target near 5%. If so, this would signal a significant shift to a pro-growth policy that limits the impact of Covid Zero next year. That controversial policy has been the main headwind for GDP growth this year, which the IMF forecasts at 3.2% and rising to 4.4% next year. Bloomberg consensus stands at 3.2% this year and 4.9% next year and so the official target wouldn’t be far off market expectations.

China reported soft November trade data. Exports came in at -8.7% y/y vs. -3.9% expected and -0.3% in October, while imports came in at -10.6% y/y vs. -7.1% expected and -0.7% in October. This was the sharpest drop in exports since February 2020, the depths of the pandemic. If the external sector remains weak, can policymakers hit a 5% GDP growth target next year largely on domestic activity? It will all boil down on the Covid numbers and how badly rising infections will impact the economy.

Reserve Bank of India hiked the repo rate 35 bp to 6.25%, as expected. The vote was 5-1. Governor Das said “Growth in India remains resilient and inflation is expected to moderate. But the battle against inflation is not over.” The bank maintained its 6.7% forecast for FY22 inflation but lowered its growth forecast to 6.8% vs. 7% seen previously. It also expects inflation to move back into the 2-6% target range in Q1. While the size of the hike was reduced from 50 bp in September, the tone was decidedly on the hawkish side and so the tightening cycle will continue. The swaps market is pricing in a peak policy rate near 6.75% vs. 6.50% at the start of this week.

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