Dollar Soft as Risk On Impulses Dominate

September 12, 2022

Win Thin

Risk sentiment remains strong as the week gets under way; risk on impulses are weighing on the dollar; U.S. yields continue to rise; there are no Fed speakers this week as the media blackout went into effect midnight Friday
ECB officials are sticking to the hawkish script; despite these comments, we believe nothing has fundamentally changed; the monthly U.K. data dump began with a whimper; the BOE meets Thursday and is expected to hike rates 75 bp to 2.5%
Japan reported August machine tool orders; the BOJ meeting next week has taken on a bit less importance with USD/JPY trading well off the recent highs

The dollar remains under pressure as the new week begins. After trading at a new cycle high Wednesday near 110.786, DXY is down for the fourth straight day and trading near 108.25. The next target is the August 26 low near 107.588. The euro has led the recovery in the foreign currencies and traded as high as $1.02 earlier. A clean break above would set up a test of the August 10 high near $1.0370. Sterling also bounced after testing the March 2020 low near $1.1410 last week but is lagging the euro and is currently trading near $1.1675. As a result, the EUR/GBP cross traded at a new high for this move near 0.8720. USD/JPY traded as low as 141.50 last week but has recovered to trade near 143 currently. We view this current dollar sell-off as corrective in nature and maintain our strong dollar call (see below). In our view, nothing has changed fundamentally and the global backdrop continues to favor the dollar and U.S. assets in general.

AMERICAS

Risk sentiment remains strong as the week gets under way. Yet it’s hard to see a reason for buying risk assets when the ECB is adding to the global headwinds. With its 75 bp hike last week with more to come, this means global liquidity is being withdrawn even faster than before. The RBA and BOC also hiked big last week, while the BOE is expected to join the ranks of the jumbo movers this week. Global growth is undoubtedly slowing and is remains to be seen whether any of these banks can engineer a soft landing. Stay tuned.

Risk on impulses are weighing on the dollar. We view this as a corrective move as we believe the relative growth and interest rate differentials still favor the greenback. EM FX has no business rallying given the global backdrop just described, especially with mainland China slowing more than expected. It may take days or perhaps weeks to resume but we continue to look for a stronger dollar.

U.S. yields continue to rise. The 2-year yield traded at a new cycle high near 3.58% today, while the 10-year yield traded near 3.34%, slightly below last week’s high near 3.36% but within sight of the June 14 high near 3.50%. This week’s inflation data will be key for the bond market even as heavy slate of issuance hits. Today, Treasury sells $41 bln of 3-year notes and $32 bln of 10-year notes. The bid/cover ratios at the last auction were 2.50 and 2.53, respectively, while indirect bidders took 63.1% and 74.5%, respectively. Hedging costs have been rising for foreign investors so it will be important to see if demand remains strong.

There are no Fed speakers this week as the media blackout went into effect midnight Friday. It remains in place until Chair Powell’s post-decision press conference on September 21. WIRP suggests over 90% odds of a 75 bp hike September 21. If the market gives the Fed 75 then, it will take it.

EUROPE/MIDDLE EAST/AFRICA

ECB officials are sticking to the hawkish message. Taking a lesson from the Fed, the bank is trying to stay on message and so far, the markets like it. Nagel said that “Thursday’s step was a clear sign and if the inflation picture stays the same, further clear steps must follow.” Elderson said “It is vital that people and companies or actors in the economy in general maintain their trust that we as the ECB will reach our of target of 2% inflation.” Guindos said “For a central bank its credibility is fundamental.”

Despite these comments, we believe nothing has fundamentally changed. Can the bank really hike rates to between 3.0-3.25% as the swaps market is pricing in? We think the ECB’s base case forecast of no recession is way too optimistic and that a downturn will eventually prevent the ECB from hiking that aggressively. That said, no one should stand in the way of this move, which is also being exaggerated by position skew going into the ECB meeting. Of note, WIRP suggests nearly 70% odds of another 75 bp hike October 27, down from fully priced in right after last Thursday’s ECB meeting.

The monthly U.K. data dump began with a whimper. July GDP came in a tick lower than expected at 0.2% m/m vs. -0.6% in June, construction came in at -0.8% m/m vs. 0.5% expected and -1.4% in June, IP came in at -0.3% m/m vs. 0.3% expected and -0.9% in June, and services index came in as expected at 0.4% m/m vs. -0.5% in June. Labor market data will be reported tomorrow and August CPI data will be reported Wednesday. Lastly, August retail sales will be reported Friday. In general, any improvements in the data are likely to be temporary as the U.K. economy is only in the early stages of sliding into recession. Indeed, most of the major real sector indicators are still showing y/y growth.

Bank of England meets Thursday and is expected to hike rates 75 bp to 2.5%. WIRP suggests such a large move is only about 60% priced in, down from nearly 85% at the start of last week. Looking ahead, the swaps market is still pricing in 275 bp of tightening over the next 12 months that would see the policy rate peak near 4.5%. Last week’s BOE testimony before Parliament was decidedly tepid, bringing into question the bank’s ability to tighten policy as aggressively as the market is pricing. For cable, a break above $1.1710 is needed to set up a test of the August 26 high near $1.19.

ASIA

Japan reported August machine tool orders. Orders rose 10.7% y/y vs. 5.5% in July and was the first acceleration since January. July core machine orders will be reported Wednesday and are expected at -0.6% m/m vs. 0.9% in June. It’s hard to see this bounce as anything but temporary given slowing regional and global growth. Domestic demand is holding up as the economy reopens but even here, rising inflation continues to squeeze household incomes.

The Bank of Japan meeting next week has taken on a bit less importance with USD/JPY trading well off the recent highs. While we expect this pair to resume its climb, markets may be reluctant to sell the yen ahead of that BOJ meeting on the off chance (very unlikely) that the bank does do some sort of pivot next month.

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