Dollar Softens as Markets Await Fresh Drivers

December 22, 2021

U.S. rates are starting to normalize; market tightening expectations for the Fed still have room to adjust; 2-year yield differentials are moving back in the dollar’s favor; we get another revision to Q3 GDP
U.K. reported Q3 current account and final GDP data; 2022 brings greater headwinds to the U.K. economy; all is not well in Turkey; Czech National Bank is expected to hike rates 75 bp to 3.50%
Japan will keep the fiscal spigots open; Thailand kept rates steady at 0.50%, as expected

The dollar is softening as risk-off impulses continue to ebb. DXY is down for the third straight day and is trading near 96.30. The euro continues to struggle to break back above $1.13, while sterling is trading back above $1.33 as markets gain confidence in another BOE hike in February. USD/JPY traded at the highest level since November 26 near 114.35 as risk on sentiment takes hold. TRY has stabilized but other markets remain under pressure (see below). We are likely in a consolidative period for now given the lack of any major new drivers. Looking ahead to an eventful January, we believe the underlying trend for a stronger dollar remains intact. U.S. rates are already moving back in the dollar’s favor and we expect that to continue (see below).

AMERICAS

U.S. rates are starting to normalize. The 2-year yield is trading around 0.68%, just below the cycle high of 0.73% from December 10. However, the long end is lagging as the 10-year yield is trading around 1.47% after rising to 1.50% yesterday. While that was the highest since December 13, it is pretty much smack in the middle of the 1.30-1.70% range that has largely held since late September. At 2.48%, the 10-year breakeven inflation rate is in the lower half of the 2.30-2.80% trading range that has largely held since late August.

Market tightening expectations for the Fed still have room to adjust. A terminal Fed Funds rate of 1.5% is priced in by the swaps market, while Fed Funds futures see a terminal rate between 1.50-1.75%. If inflation returns to the 2% target, then that implies a negative real policy rate at the end of a Fed tightening cycle, with the economy near full employment. Sure, there are downside risks from more variants but the rates market seems to be pricing in perfection from the Fed. We continue to believe that markets are underestimating the Fed’s propensity to tighten, and this should lead to a further rise in U.S. short-term rates in 2022.

The 2-year yield differentials are moving back in the dollar’s favor. The U.S.-German differential is currently 136 bp, just shy of the December cycle high near 139 bp. The U.S.-Japan differential is currently 76 bp, just shy of the December cycle high near 80 bp. It’s clear that the ECB and BOJ are going nowhere fast, and so the bulk of the expected moves in these differentials will come from the U.S. side.

We get another revision to Q3 GDP. Growth is expected to remain steady at 2.1% SAAR, but this is old news. Q4 is looking much stronger, with the Atlanta Fed’s GDPNow model tracking 7.2% SAAR vs. 7.0% previously. Bloomberg consensus sees 6.0% SAAR in Q4, slowing to 4.0% in Q1 and 3.6% in Q2. With Germany tipping into recession, the eurozone growth outlook has worsened and so the U.S. economy is likely to continue outperforming for the time being. November Chicago Fed National Activity Index (0.40 expected), existing home sales (3.0% m/m expected), and December Conference Board consumer confidence (111.0 expected) will also be reported today.

EUROPE/MIDDLE EAST/AFRICA

U.K. reported Q3 current account and final GDP data. The q/q growth rate was revised down a couple of ticks to 1.1%, while the y/y rate was revised up a couple of ticks to 6.8%. Private consumption was revised up to 2.7% q/q from 2.0% preliminary, while government spending was revised down to -0.5% q/q from 0.9% preliminary. GFCF was revised down to -0.9% q/q from 0.8% preliminary, while the drag from net exports rose slightly. The shift from government spending to private spending is to be expected as public support programs are pared back. However, the drop in investment and net exports is disappointing as it’s clear that Brexit has yet to deliver anything much beyond increased uncertainty for the nation’s international trade.

Looking ahead, 2022 brings greater headwinds to the U.K. economy. The BOE is expected to deliver another 100 bp of tightening over the next twelve months. If the rate hikes develop as projected, they will trigger an end to the reinvestment phase of QE as well as the eventual start of active balance sheet shrinkage via asset sales. According the BOE’s strategy report from the summer, reinvestment would end when the policy rate reaches 0.5% and active balance sheet shrinkage would begin when the policy rate reaches 1.0%. On top of this, fiscal policy will no longer be accommodative as Chancellor Sunak works on fiscal consolidation, while trade frictions are likely to remain high as Brexit continues to fester.

All is not well in Turkey. While the lira has stabilized after the support plan was announced, equity markets continue to plunge and trading was halted after the circuit-breaker was triggered with another 5% drop. Elsewhere, credit defaults swaps are trading at the highest in nearly two years, signaling doubts about its ability to repay its external debt. The more policymakers work to prevent the lira from adjusting, the more that imbalances will show up in other asset markets. As we warned earlier this week, the plan simply transfers currency risk from households and firms on to the government. It did nothing to address the root cause of the crisis, which is too loose monetary policy. Until orthodox policies return, Turkish assets will continue to struggle.

Czech National Bank is expected to hike rates 75 bp to 3.50%. A couple of analysts look for a smaller 50 bp move, while one looks for a bigger 100 bp move. CPI rose 6.0% y/y in November, the highest since October 2008 and further above the 1-3% target range. At the last meeting November 4, the bank delivered a hawkish surprise with a 125 bp hike to 2.75%. Governor Rusnok said then that smaller hikes would be seen going forward. Since that meeting, he said he sees rates closer to 4% than 3% in 2022. Of note, the swaps market sees a terminal rate of 3.75% in H1 before falling to 3.25-3.50% by end-2022 and then 2.50-2.75% by end-2023. We think this understates the case and that the bank will need to hike more to stabilize inflation.

ASIA

Japan will keep the fiscal spigots open. Reports suggest the budget for FY22 starting April 1 will increase to JPY107.6 trln ($943 bln), up nearly 1% from the initial spending plan for FY21. Supplementary budgets typically end up boosting these figures before the fiscal year ends. Tax revenues are expected to rise to a record JPY65.2 trln, which will help limit new bond issuance to JPY36.9 trln, down from the initial plan for FY21 budget issuance of JPY43.6 trln. Japan has not been hit hard by the omicron variant yet but it’s clear that policymakers are taking no chances. Japan’s loose monetary and fiscal policy stances certainly stand out in world where most nations are paring back accommodation. To us, this means that the yen should continue to underperform.

Bank of Thailand kept rates steady at 0.50%, as expected. It lowered its growth forecast for 2022 to 3.4% from 3.9% previously but raised its 2021 forecast to 0.9% from 0.7% previously. The bank “assessed that the omicron outbreak would affect the economy in early 2022. The impact could be more severe and prolonged than expected due to downside risks such as the severity of the outbreak and the strictness of corresponding containment measures.” The bank acknowledged that headline inflation had risen recently due to supply-side factors, particularly energy prices, but viewed this as temporary and expected to fall in H2 2022. Elsewhere, the cabinet approved a medium-term fiscal plan that projects a steady rise in the budget deficit during FY2023-FY2026 to help support the economic recovery from the pandemic. It’s clear that both monetary and fiscal policies will remain accommodative for the next several years, as Thailand was one of the hardest hit by the pandemic.

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