Dollar Soft as U.S. Yields Plunge

October 10, 2023

Win Thin

U.S. Treasury yields have plunged as bond market reopened after the U.S. holiday; Fed tightening expectations have fallen sharply; only minor data will be reported
The conflict in Israel is about to intensify; ECB officials are cautious about the impact of developments in Israel; Italy reported firm August IP; BOE released the minutes of its financial policy meeting; Norway reported soft September CPI data
Reports suggest the BOJ may raise its FY23 core inflation forecast to around 3%; Japan reported August current account data; China policymakers are considering a new round of stimulus financed by new debt issuance; troubled property developer Country Garden will likely default on its debt

The dollar is trading lower as the U.S. returns from holiday. DXY is trading lower near 105.88 as U.S. yields plunge. The euro is trading higher near $1.06 while sterling is trading higher near $1.2265. USD/JPY is trading higher near 149. We believe this current dollar weakness is corrective in nature. Looking beyond the potential intervention noise, nothing fundamentally has changed and we see no reason to believe the dollar’s uptrend has ended. Friday’s jobs data confirm that the U.S. economy is still running hot and needs further tightening.

AMERICAS

U.S. Treasury yields have plunged as bond market reopened after the U.S. holiday. The 10-year yield traded as low as 4.62% vs. last week’s high near 4.89% but has since recovered to 4.67%, while the 30-year yield traded as low as 4.80% vs. last week’s high near 5.05% but has since recovered to 4.85%. The short end also took part in the rally, as the 2-year yield traded as low as 4.92% vs. last week’s high near 5.18% but has since recovered to around 5.0%. Some Fed officials have recently been highlighting the potential tightening impact of higher U.S. yields but that may be called into question if this drop in yields is sustained.

Fed tightening expectations have fallen sharply. WIRP suggests only 15% odds of a hike November 1 and topping out near 30% December 13. Both are down sharply from last week but we think the market is very wrong about the Fed, as it's been this whole cycle. The first Fed cut has been moved forward to June from July previously, which is also wrong. Bostic, Waller, Kashkari, and Daly speak today. Bostic is the lone dove in this group and so we expect some pushback from the other three to the dovish market pricing for Fed policy.

Only minor data will be reported. September NFIB small business optimism came in at 90.8 vs. 91.0 expected and 91.3 in August. This was the lowest since May. August wholesale inventories and trade sales will be reported later today. The Atlanta Fed’s GDPNow model is currently tracking Q3 growth at 4.9% SAAR. Next model update comes today after the data.

EUROPE/MIDDLE EAST/AFRICA

The conflict in Israel is about to intensify. Reports suggest Israel is building up its forces near Gaza in preparation for the next phase of retaliation. Fighting remains ongoing and the death toll continues to rise, but the next phase will likely lead to a surge in deaths. USD/ILS is trading just below 4.0 and is on track to test the March 2015 high near 4.0680. After that is the July 2012 high near 4.10. Bank of Israel intervention is likely preventing even greater weakness but it may be forced to hike rates to lend further support and limit inflationary impulse stemming from currency weakness. Next policy meeting is October 23 but an intra-meeting move is very possible.

ECB officials are cautious about the impact of developments in Israel. Villeroy said “We forecast inflation to land toward 2% between now and 2025 - today we don’t see any reason to change this landing. The point to be the most vigilant on is an extension of the conflict.” Holzmann said the ECB tightening cycle could end “if everything goes well” but added that “if additional shocks come, and if the information we have proves to be incorrect, we may have to hike another time or perhaps two times.” Markets do not believe him right now. WIRP is pricing in no more ECB rate hikes but more importantly, nearly 60% odds of a cut in April that becomes fully priced in for June 6, presumably due to a deep recession. This is very euro-negative, to state the obvious.

Italy reported firm August IP. IP came in at 0.2% m/m vs.-0.3% expected and a revised -0.9% (was -0.7%) in July, while the y/y rate came in at -4.2% vs. -5.0% expected and a revised -2.3% (was -2.1%) in July. On Monday, German IP came in at -0.2% m/m vs. -0.1% expected and a revised -0.6% (was -0.8%) in July, while the y/y rate came in at -2.0% vs. -1.5% expected and a revised -1.7% (was -2.1%) in July. Eurozone IP will be reported Friday and is expected at 0.1% m/m vs. -1.1% in July, while the y/y rate is expected at -3.5% vs. -2.2% in July.

Bank of England released the minutes of its financial policy meeting. The Financial Policy Committee warned that house prices are likely to fall further in many countries, and said it would continue to closely monitor developments in China and Hong Kong as well as “the potential for spillovers to U.K. financial stability.” The FPC also noted that U.K. household finances remain under pressure from rising interest rates and that the share of households with high debt servicing ratios is expected to keep rising next year. However, it added that this share will likely stay below the historic peak in 2007. The good news is that the tightening cycle may already have ended. WIRP suggests nearly 30% odds of a hike November 2, rising 50% December 14 and topping out near 60% in Q1. The first cut is not expected until Q4 2024.

Norway reported soft September CPI data. Headline came in at 3.3% y/y vs. 4.0% expected and 4.8% in August, while underlying came in at 5.7% y/y vs. 6.1% expected and 6.3% in August. Headline was the lowest since January 2022 but still above the 2% target. At the last policy meeting September 21, Norges Bank hiked rates 25 bp to 4.25%, as expected. Governor Bache said “There will likely be one additional policy rate hike, most probably in December” and added that “There will likely be a need to maintain a tight stance for some time ahead.” The CPI data have injected some doubts into the market as WIRP suggests zero odds November 2 that rise to around 50% December 14.

ASIA

Reports suggest the Bank of Japan may raise its FY23 core inflation forecast to around 3%. Update macro forecasts will be released at the upcoming meeting October 30-31. However, the true signal will come from its FY24 and FY25 forecasts, which currently see core inflation falling back below the 2% target. BOJ liftoff expectations have been pushed out from last week. WIRP now suggests no odds October 31, 20% December 19, 50% January 23, 75% March 19, and fully priced in for April 26..

Japan reported August current account data. The adjusted surplus came in at JPY1.63 trln vs. JPY2.41 trln is expected and JPY2.77 trln in July. However, the investment flows will be of more interest. The August data showed that Japan investors were net buyers of U.S. bonds (JPY643 bln) again and for three of the past four months. Japan investors remained net buyers (JPY142 bln) of Australian bonds for the sixth straight month after eight straight months of net selling, and remained net sellers of Canadian bonds (-JPY30 bln) for the second straight month and for seven of the past eight months. Investors were net sellers of Italian bonds (-JPY106 bln) after two straight months of buying. Overall, Japan investors were total net buyers of foreign bonds (JPY2.0 trln) again and for three of the past four months. With Japan yields moving higher, it’s possible that Japan investors will stop chasing higher yields abroad but it’s way too early to say.

Reports suggest China policymakers are considering a new round of stimulus financed by new debt issuance. The government may issue at least CNY1 trln ($137 bln) of additional sovereign bonds to finance spending on infrastructure projects. As a result, the government is also considering raising its budget deficit target for 2023 well above the -3% of GDP set in March. Sources say an official announcement may come as early as this month but discussions are ongoing. This is yet another muddle through measure on the fiscal side that is meant to complement muddle through measures on the monetary side. Both may boost growth but will not address the core problem of the existing debt overhang. China’s debt to GDP ratio is approaching 300% before any new deficit spending is accounted for.

In related news, troubled property developer Country Garden will likely default on its debt. In a stock exchange filing, the company acknowledged that it won’t be able to service all of its offshore debt obligations. It added that it had not made a HKD470 mln ($60 mln) and comes after it missed initial deadlines last month to make $55.4 mln of interest payments on two dollar bonds. Those grace periods are set to end October 17, 18, and 27, respectively. According to Bloomberg, Country Garden has $11 bln of offshore notes outstanding. To illustrate just how troubled it is, the company announced that September contracted sales plunged -81% y/y vs. -72% in August.

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