Dollar Soft in the Wake of FOMC Minutes

May 26, 2022

U.S. yields continue to fall from the early May peaks; FOMC minutes are worth discussing; we disagree with the markets’ dovish take; Kansas City Fed President George will retire in January; we get our first revision to Q1 GDP; regional Fed manufacturing surveys will continue to roll out; the only major Canada data this week is March retail sales

The ECB signaled it is in no hurry to begin QT; it seems to be following the Fed’s old playbook, stretching out the sequential steps of tightening; ECB balance sheet runoff clearly has implications for the peripheral countries; Turkey central bank kept rates steady at 14.0%, as expected; Russia central bank cut rates 300 bp to 11.0% vs. 250 bp expected

BOJ Governor Kuroda said rate hikes by the Fed won’t necessarily cause the yen to weaken; RBNZ Governor Orr reiterated that it needs to raise interest rates “at pace” to prevent inflation expectations from becoming unanchored; RBNZ tightening expectations continue to adjust; China’s Premier Li Keqiang continues to sound the alarm about the slowing economy; Philippines President-elect Marcos will nominate central bank Governor Diokno to Secretary of Finance

The dollar continues to struggle after the FOMC minutes.  DXY is trading near 101.90 on the markets’ dovish take on the minutes (see below).  Key level to watch is 101.80 as clean break below would set up a test of the April 21 low near 99.818.  The euro is trading above $1.07 and is nearing a test of this week’s high near $1.0750.  USD/JPY remains heavy near 127 as risk sentiment remains vulnerable.  Sterling is trading back above $1.26 to a new cycle high near $1.2620.  We still view this recent move lower as a correction within the longer-term dollar rally but we continue to be surprised at how far the dollar has fallen from the early May peak. We continue to believe that pessimism regarding the U.S. is overdone, with markets overlooking the problematic fundamental outlooks for the eurozone, U.K., and Japan.


U.S. yields continue to fall from the early May peaks.  The 10-year yield is currently trading near 2.76% vs. the May 9 peak near 3.20%,while the 2-year yield is trading near 2.48% vs. the May 4 peak near 2.85%.  Part of this drop has been some persistent risk-off impulses, but we feel a large part of it reflects concerns about the economic outlook due to some soft U.S. survey data.  This has also led Fed tightening expectations lower, with the swaps market now pricing in a terminal Fed Funds rate of 3.0% vs. 3.75% in early May.  More importantly, it is now pricing in the start of an easing cycle sometime in the subsequent 12 months.  This would only be likely if the U.S. economy were to fall into recession next year.  While that is possible, it is not our base case. 

FOMC minutes are worth discussing.  Key points: 1) "Most participants judged that 50 bp increases in the target range would likely be appropriate at the next couple of meetings." - nothing was said about a pause but we think the Fed simply didn’t want to box themselves into a preset path beyond the July 26-27 FOMC meeting; 2) “At present, participants judged that it was important to move expeditiously to a more neutral monetary policy stance.  They also noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.” - with most policymaker viewing neutral as around 2.5%, this implies Fed Funds at 3.0%or above; 3) “Many participants judged that expediting the removal of policy accommodation would leave the Committee well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.” - some think this hints at a pause but it could easily hint at a faster pace  of tightening; it really is data-dependent after September.

We disagree with the market’s dovish take on the minutes.  The dollar has softened after the FOMC minutes and U.S. yields have fallen.  To us, the views expressed in the minutes are about all they could say at the start of an aggressive tightening cycle where no one really knows how far rates have to go.  The Fed is facing a very complicated situation and so is trying to burnish its hawkish credentials while trying not to pre-commit to any rate path.  The minutes clearly reflect this balancing act.  Brainard speaks today. 

Federal Reserve Bank of Kansas City President George will retire in January.  This comes after Chicago Fed President Evans announced his retirement around the same time as well.  Both are required to step down by mandatory retirement rules for Reserve Bank presidents, as both will be turning 65.  Note that the boards of the regional Fed banks choose their presidents, while President Biden is responsible for any vacancies on the Fed’s Board of Governors in Washington D.C.  In related news, Michael Barr is likely to be confirmed by the Senate to fill the empty post of Vice Chair for supervision as all 50 Democrats have expressed their support.

We get our first revision to Q1 GDP.  While this is old news, it is expected at -1.3% SAAR vs. -1.4% previously. We see risks of a larger upward revision in light of the large upward revision to March retail sales data, as the so-called control group used for GDP calculations was revised to 1.1% m/m vs. -0.1% previously.  Markets are already looking ahead to Q2 and the Atlanta Fed’s GDPNow model is currently tracking 1.8% SAAR growth, down from 2.4% last week.  The next update to the model comes this Friday.  

Regional Fed manufacturing surveys will continue to roll out.  Kansas City is expected at 18 vs. 25 in April.  So far, Empire came in at -11.6 vs. 24.6 in April, Philly Fed came in at 2.6 vs. 17.6 in April, and Richmond Fed came in at -9 vs. 14 in April.  Yet preliminary May S&P Global (formerly Markit) PMI came in at 57.5 vs. 57.7 expected and 59.2 in April, which suggests that the regional Fed surveys are overstating weakness in that sector. Weekly jobless claims and April pending home sales (-2.0% m/m expected)  will also be reported.  Continuing claims will be of interest as they are for the BLS survey week containing the 12th of the month and are expected at 1.310 mln vs 1.317 mln the previous week.  Current NFP consensus stands at 332k vs. 428k in April, with the unemployment seen falling a tick to a cycle low 3.5%.

The only major Canada data this week is March retail sales today.  Headline is expected at 1.4% m/m vs. 0.1% in February, while ex-auto is expected at 2.1% m/m vs. 2.1% in February.  The economy is humming along even as inflation continues to accelerate.  WIRP suggests a 50 bp hike June 1 is fully priced in.  Looking ahead, the swaps market is now pricing in 175-200 bp of tightening  over the next 12 months that would see the policy rate peaking between 2.75-3.0%, down from 3.25% at the start of last week.  


ECB signaled it is in no hurry to begin Quantitative Tightening (QT).  Noted uber-hawk Knot said "I don't expect any discussion on that [QT] at least for the remainder of this year and into next year. So we will focus on rates.  That will imply that we will have a large balance sheet for still some time to come."  We think this is new forward guidance with regards to balance sheet runoff and should be seen as euro-negative.  Why?  Contrast the ECB with the Fed, which first hiked rates  March 16 and then hiked 50 bp May 4 and announced aggressive QT beginning June 1.  The Fed has tapered, hiked, and will start QT over a span of six months, compressing  a timeline that was well over three years back in the 2014-2017 tightening cycle.  

The ECB seems to be following the Fed’s old playbook, stretching out the sequential steps of tightening.  In a sense, this cautiousness is to be expected as it’s the ECB’s first tightening cycle in over 10 years and also it’s first to exit negative rates and QE.  The Fed has a more “been there, done that” perspective and seems much more comfortable with an aggressive pace of tightening.  Of note, ECB tightening expectations remain subdued.   Liftoff July 21 remains fully priced in.  However, the swaps market is now pricing in only 150 bp of tightening over the next 12 months followed by another 25 bp of tightening priced in over the following 12 months that would see the deposit rate peak near 1.25% vs. 1.75% at the start of the month.  As a result, the ECB’s cautious expected tightening path suggests monetary policy divergencies will continue to widen in favor of the dollar.   

ECB balance sheet runoff clearly has implications for the peripheral countries.  The 10-year spreads to Germany for Italy, Greece, and Spain have all moved up over the course of this year to levels not seen since early 2020, when the pandemic was roiling financial markets worldwide.  However, Knot’s comments have helped slow the move higher a bit today but make no mistake, the peripheral countries were the biggest beneficiaries of ECB QE and so will be hardest hit when the bank begins QT.  Luckily for them, this appears to be a 2023 story. 

Turkey central bank kept rates steady at 14.0%, as expected.  It seems to be signaling some action ahead, as it said collateral and liquidity steps will be taken once the current policy framework review is completed.  Despite inflation accelerating to 70% y/y in April, the highest since February 2002, the bank has kept rates steady since its last 100 bp cut back in December.  We believe the country is nearing a moment of reckoning.  After the recent effort to attract foreign investors fell flat, it appears foreign reserves are being rapidly depleted.  The most recent central bank figures show a $4.8 bln decline last week in gross reserves to $61.2 bln, the lowest since last July.  The twin deficits are growing and need to be financed by offering higher rates and so we believe the central bank will eventually be forced to hike in the coming months.  Until that happens, USD/TRY is likely to drift higher and test the December high near 18.3635. 

Russia central bank cut rates 300 bp to 11.0% vs. 250 bp expected.  It has now cut rates a total of 900 bp from the 20% peak despite inflation of 17.83% y/y in April.  Of note, the bank said inflation was 17.5% y/y as of May 20.  Markets were truly split about the outcome; of the 23 analysts polled by Bloomberg, 11 saw a 200 bp cut, 2 saw 250 bp, 6 saw 300 bp, 1 saw 350 bp, 2 saw 400 bp, and 1 saw 500 bp.  The bank said inflation has been slowing in recent week and so it will consider further cuts at its next meetings.  This was an unscheduled meeting ahead of the next scheduled meeting June 10.  While that is two weeks away, another cut seems likely then if reported inflation does indeed ease.   

Russia has come up with a scheme to services its external debt in rubles.  Due to an expiring sanctions waiver, Russia can no longer use U.S. banks to make any dollar bond payments as of midnight last night.  While the intent to pay is there, payment in rubles would violate the terms of the dollar-denominated bonds and would still constitute a default event.   A payment is due this Friday but there is a 30-day grace period before Russia would technically be in  default. 


Bank of Japan Governor Kuroda said rate hikes by the Fed won’t necessarily cause the yen to weaken.  He noted that Fed rate hikes “may affect the value of US government bonds and stock prices.  So I think it’s not necessarily the case that Japan’s capital will flow into the U.S. continuously, causing the yen to weaken.”  Kuroda stressed that there was no single decisive factor that determines exchange rates.  While Kuroda is correct to point out that long run exchange rates are determined by many factors (inflation differentials, productivity, etc.), we do believe the interest rates differentials are the major determinant of exchange rates over the short run.  Lastly, Kuroda said the BOJ would handle any eventual exit path well, though it won’t be easy.  The knee-jerk reaction was to take the yen higher but we note that he was simply responding to a hypothetical question, not signaling imminent tightening.

RBNZ Governor Orr reiterated that it needs to raise interest rates “at pace” to prevent inflation expectations from becoming unanchored.  These comments echo the RBNZ statements from the past two meetings that underscored the need for 50 bp moves.  Orr added that “We believe that the worst outcome, which we most want to avoid, is one where inflation expectations become persistent.  What are people thinking about where inflation will be two years ahead, five years ahead, we want that to remain anchored. If they start drifting up with current inflation, that’s when we get concerned.”  The good news here is that the RBNZ has so far been successful; while 1-year inflation expectations continue to move higher, 2-year expectations appear to be leveling out.   

RBNZ tightening expectations continue to adjust.  WIRP suggests 50 bp hikes in July and August are almost fully priced in, but then it gets fuzzy after that as markets are pivoting towards 25 bp moves thereafter.  Looking ahead, the swaps market is now pricing in 175 bp of tightening  over the next 12 months that sees the policy rate peak near 3.75%, down from 4.50% yesterday after the RBNZ set out a hawkish rate path that peaks near 4.0% in Q3 23 vs. a 3.35% peak in 2024 seen in the February projections. 

China’s Premier Li Keqiang continues to sound the alarm about the slowing economy.  His comments were made to thousands of local officials at an emergency meeting yesterday and were reportedly much more alarming than the official accounts published by state media.  Li reportedly told the attendees that growth risked slipping below a “reasonable” range and warned that China will face a much longer road to recovery if the economy doesn’t keep expanding at a certain rate.  He stressed that growth must be positive in Q2.  Li reportedly listed some objectives for local officials to focus on this year, including better balancing of Covid measures and economic growth.  Li also urged local authorities to carry out the stimulative policies that the central government has introduced in recent months, stressing that growth is the key to solving all the problems facing China, including job creation, income stability, and containing the pandemic.  This is clearly a message to President Xi, who has prioritized COVID Zero over the economy.  Will Xi listen?  Stay tuned.

Reports suggest Philippines President-elect Marcos will nominate central bank Governor Diokno to Secretary of Finance.  Diokno’s term as governor  is schedule to end mid-2023 and Marcos will appoint current central bank board member Felipe Medalla to serve the remainder of his term beginning this July 1.  Both are well-respected by the markets and Marcos is clearly making market-friendly choices to head up his economic team.  After his appointment was announced, Diokno said “Maybe the first item in the agenda will be the sustainability of our public debt.”  On the other hand, Medalla’s first task will be continuing the fight to get inflation back in the 2-4% target range.  Next policy meeting is June 23 and will be the last under Diokno. After last week’s liftoff, he said future moves would be data-dependent and we believe another 25 bp hike to 2.5% then seems likely.  

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