Dollar Softer After the FOMC Decision

July 29, 2021
  • Markets are still digesting the Fed’s hawkish hold; we believe that tapering and rate hikes will both happen sooner than the market expects; weekly initial jobless claims will be closely watched; we also get our first look at Q2 GDP; a compromise was struck on the traditional infrastructure package but the $3.5 trln “human infrastructure” package will face difficulties; Peru finally has an official president, and he continues to sound appeasing of market fears
  • Key eurozone inflation readings are starting to emerge; rising inflation is causing some consternation for the ECB hawks but doves have the upper hand
  • Virus numbers in Japan are worsening; market expectations for RBA tapering have shifted as lockdowns bite; there was a big turnaround in Chinese stocks overnight, led by an unexpected policy reversal by Beijing
The dollar is softer in the wake of the FOMC decision. DXY is down for the fourth after two straight day and is trading just above 92. A break below sets up a test of the June 25 low near 91.525. The euro is trading at the highest level since July 12 near $1.1880, and a break above $1.1890 would set up a test of the June 25 high near $1.1975. Sterling is trading at the highest level since June 24 near $1.3970 and is on track to test the June 23 high near $1.40. A break above that would set up a test of the June 1 high near $1.4250. USD/JPY remains heavy and a break below 109.65 would set up a test of the July 19 low near 109.05.
 
AMERICAS

Markets are still digesting the Fed decision. Price action has been choppy, to put it mildly, with some “buy the rumor, sell the fact” being seen. It also seems the FX market is focusing more on Powell’s dovish stance on rate lift-off rather than the Fed’s more hawkish stance on tapering. In terms of rates, the 10-year UST yield is off yesterday’s low near 1.22% to trade around 1.27% currently, while the 10-year breakeven inflation rate has edged higher to 2.41%. It will likely take a few days to get past the noise but we believe the most important signal for the markets is that the Fed is likely to start removing accommodation sooner than markets are expecting. That is ultimately dollar-positive.

The Fed delivered a hawkish hold, as we expected. All policy settings were unchanged but tapering was mentioned in the official statement for the first time this cycle, with the Fed noting that there has been progress made towards the goals laid out to justify tapering. This was a very hawkish surprise and we believe it moves the timeline for actual tapering up a bit. We now think it's likely that an explicit tapering statement is made at the August 26-28 Jackson Hole Symposium followed by actual tapering seen by year-end. Of course, it will depend in large part on the data but we remain confident the US economy will remain strong.

On the other hand, Chair Powell stressed that the Fed is clearly “a ways away” from hiking rates. He noted that most inflation being seen is related to reopening the economy and that it will likely fall over the medium-term. The Fed continues to portray the current spike in inflation as transitory but stressed that it will use the tools at its disposal to limit price pressures if it is wrong. Powell was also upbeat about the labor market, predicting that it shouldn’t take long to see maximum employment. He noted that the U.S. is “clearly on the path to a very strong labor market.” Taking this a step further than Powell, we note that this would imply higher wages are on the way and this in turn would turn inflation from transitory to something stickier.

Much will depend on the data but we believe that tapering and rate hikes both happen sooner than the market expects. This is because we remain very optimistic about the U.S. economic outlook and see heightened inflation risks ahead. Current consensus sees tapering in early 2022 and rate hikes in early 2023, but we believe that the timing for both have been moved up into late 2021 and late 2022, respectively. Contrast this to the BOJ and ECB, which over the past two weeks have signaled that rate hikes are unlikely until 2024 at the earliest. This ongoing central bank divergence is central to our strong dollar call for H2.

Weekly initial jobless claims will be closely watched. Initial claims are expected at 385k vs. 419k the previous week. That was the highest since mid-May and were especially disappointing as they are for the BLS survey week containing the 12th of the month. Continuing claims are reported with a one-week lag and so this week’s reading is for the BLS survey week. They are expected at 3.183 mln vs. 3.236 mln the previous week. Unfortunately, the recent claims data underscore the ongoing unevenness in the labor market recovery.

Current consensus for July NFP is currently 926k, up from 750k earlier this week and 850k actual in June. Average hourly earnings are expected to rise 3.9% y/y vs. 3.6% in June. There are still distortions aplenty but this is worth keeping an eye on as pre-pandemic, average hourly earnings were rising 3.0-3.5% y/y. We see upside risks for a 4-handle but nothing more specific. Most inflation measures have surprised to the upside for the last couple of months so we'll go with the trend.

We also get our first look at Q2 GDP. Consensus sees growth of 8.5% SAAR vs. 6.4% SAAR in Q1. The Atlanta Fed’s GDPNow model forecasts Q2 growth at 6.4% SAAR, while the New York Fed’s Nowcast model currently shows Q2 growth at a more modest 3.2% SAAR and estimates Q3 growth at 4.1% SAAR. Of note, Bloomberg consensus sees growth of 7.1% in Q3 and 5.0% in Q4, all in SAAR terms as above trend growth is expected to persist into 2022. June pending home sales will also be reported today and are expected to rise 0.1% m/m vs. 8.0% in May.

A compromise was struck on the traditional infrastructure package. The bipartisan group of Senators and the White House reached a tentative agreement yesterday on a $550 bln infrastructure bill. The agreement cleared the way for a 67-32 Senate vote last night that will now lead to floor consideration of the plan. Many details are still being hammered out but the Senate could pass the bill this weekend or early next week. 60 votes are needed and Majority Leader Schumer said “I believe we have the votes for that.”

On the other hand, the $3.5 trln “human infrastructure” package will face difficulties. Democratic Senator Sinema said that while she supports moving ahead with negotiations on the plan, she won’t support spending the full $3.5 trln proposed. She said her vote hinges on the outcome of negotiations on its size. Democrats plan on passing this under the budget reconciliation process, which means that they need all 50 to sign on so that Vice President Harris can cast the tie-breaking vote. However, Budget Chairman Sanders said last night that he has the 50 votes to pass it. To be continued.

Peru finally has an official president, and he continues to sound appeasing of market fears. Pedro Castillo was sworn in yesterday and observers widely expect Pedro Francke to become the Minister of Finance. His speech reaffirmed that he does not intend to nationalize businesses, but he criticized the economic practices of the 90s. Of course, there are still plenty of radicals in his side and markets will remain on edge about the lingering issue of rewriting the constitution. But all in all, it looks like he will try to walk the fine line between populism (transfers and supporting low income households) without spooking markets. We prefer to stay on the side lines with Peruvian assets for the time being. The sol is off its lows but has been flatlined for the last few weeks.
 
EUROPE/MIDDLE EAST/AFRICA

Key eurozone inflation readings are emerging. Germany will report July CPI shortly, with headline inflation (EU Harmonized) is expected at 2.9% y/y vs. 2.1% in June. If so, it would be the highest since October 2011. However, German state readings already reported today suggest upside risks to the national number. Spain reported July CPI earlier, with headline inflation (EU Harmonized) rising the expected 2.9% y/y vs. 2.5% in June. France reports early tomorrow, with headline inflation (EU Harmonized) expected at 1.4% y/y vs. 1.9% in June. Eurozone July CPI follows France tomorrow. Headline inflation is expected at 2.0% y/y vs. 1.9% in June, while core is seen falling a couple of ticks to 0.7% y/y.

We know rising inflation is causing some consternation for the ECB hawks. Yet Lagarde and the doves clearly have the upper hand right now. As we’ve seen in the U.S., eurozone bond yields have reversed this year’s H1 rise and have fallen sharply so far in H2. German 10-year yield is trading at the lowest since February, while the 2-year is trading at the lowest since December. Most others, including Italy, have seen similar price action and so the ECB can feel confident that its efforts to maintain its accommodative stance are paying off. Firms are recovering even as consumer sentiment rose to 119 in July, the highest since the series began in 1985.
 
ASIA

Virus numbers in Japan are worsening. Tokyo saw 3,865 new cases today, the third straight daily record, while reports suggest national new cases is expected to top 10,000 for the first time ever. As a result, the government is reportedly considering whether to extend the state of emergency in Tokyo and the southern island of Okinawa beyond the current scheduled end of August 22. More Olympic athletes have tested positive, and so the decision to forge ahead with the Olympic Games may come back to haunt Prime Minister Suga as he seeks reelection this fall. With the economy likely to continue suffering in Q3, we expect another fiscal package in the coming weeks.

Market expectations for RBA tapering have shifted as lockdowns bite. Sydney’s monthlong lockdown has been extended until late August as the virus numbers worsen. With lockdowns and lockdown protests roiling the economy, many analysts are now looking for GDP to contract in Q3. A Bloomberg poll taken this week shows that most analysts look for the RBA to delay its planned tapering. Of the 18 analysts polled, 13 expect the bank to announce this at next week’s meeting, while 5 see tapering proceeding as planned in September. While one well-known RBA watcher calls for an increase in weekly QE to AUD6 bln from AUD5 bln currently, more than 80% of the poll respondents see no increase. Despite the worsening news stream, AUD is trading at the highest level since July 19 and is testing the .74 level. Still, AUD has retraced only about a third of this month’s losses. A break above .7480 is needed to set up a test of the July 6 high near .7600. This will be increasingly difficult if the RBA does make a dovish pivot next week.

There was a big turnaround in Chinese stocks overnight, led by an unexpected policy reversal by Beijing. Authorities said that they would continue to allow Chinese companies to offer IPOs in U.S. markets as long as they meet listing requirements. This happened during a meeting between regulators and major investment banks, which in itself is a sign that the sharp decline in asset prices is making Beijing uncomfortable. On top of this, the PBOC conducted an unusual liquidity injection (worth $4.6 bln for the 7-day repo), further driving home the point. The Shanghai Composite was up 1.5% on the day while the Hang Seng tech index jumped 7% and is now down “only” 18% on the year.

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