Dollar Steadies Ahead of the Weekend

January 20, 2023

Win Thin

U.S. financial conditions continue to loosen; Fed officials remain hawkish; housing data should show further weakness; weekly jobless claims show continued strength in the labor market
The account of the ECB’s December 15 meeting tilted hawkish; ECB President Lagarde remains hawkish; U.K. reported very weak December retail sales; BOE Governor Bailey sounded a bit less hawkish
Japan reported December national CPI; BOJ tightening expectations have steadied; China’s commercial banks kept their LPRs steady, as expected

The dollar has steadied ahead of the weekend. DXY is trading modestly higher near 102.244 after two straight down days. After making a new cycle low this week near 101.528, DXY is on track to test the May low near 101.297. The euro is trading flat near $1.0830 after making a new cycle high this week near $1.0885, and remains on track to test the April high near $1.0935. Sterling is trading lower near $1.2360 after weak retail sales data (see below). After making a new cycle high this week near $1.2435, cable remains on track to test the December high near $1.2445. Break above that would set up a test of the May high near $1.2665. USD/JPY is trading higher near 130 and a break above that would set up a test of the post-BOJ high this week near 131.60. While we believe that the current dollar weakness is overdone, we continue to respect the price action. Until a more hawkish Fed narrative emerges, the dollar is likely to remain under pressure.

AMERICAS

U.S. financial conditions continue to loosen. According to the Chicago Fed, conditions ended last week at the loosest since mid-April. We are likely to see further loosening this week as yields fell and the dollar weakened. Despite recent disinflationary trends, we do not believe Fed officials will be happy with this premature loosening and should push back forcefully. Harker and Waller speak today. At midnight tonight, the media embargo goes into effect and there will be no more Fed speakers until Chair Powell’s post-decision press conference February 1. If the Fed does downshift again at that meeting to 25 bp, Powell will have to sell it in such a way that the markets won’t take financial conditions even looser. Of note, new Dot Plots and macro forecasts won’t come until the March 21-22 FOMC meeting.

Fed officials remain hawkish. Yesterday, Collins said “Now that rates are in restrictive territory and we may, based on current indicators, be nearing the peak, I believe it is appropriate to have shifted from the initial expeditious pace of tightening to a slower pace. More measured rate adjustments in the current phase will better enable us to address the competing risks monetary policy now faces.” She added that Fed is likely to hike rates to just above 5% and keep them there for some time. Elsewhere, Brainard said “Even with the recent moderation, inflation remains high, and policy will need to be sufficiently restrictive for some time to make sure inflation returns to 2% on a sustained basis.” WIRP suggests a 25 bp hike February 1 is fully priced in, with less than 10% odds of a larger 50 bp move. Another 25 bp hike March 22 is almost priced in, while one last 25 bp hike in Q2 is only about 30% priced in. Furthermore, the swaps market continues to price in an easing cycle by year-end and we just don’t see that happening.

Housing data should show further weakness. December existing home sales are expected at -3.4% m/m vs. -7.7% in November. With the Fed continuing to tighten, weakness in housing is expected to intensify.

Weekly jobless claims show continued strength in the labor market. Initial claims came in at 190k vs. 214k expected and 205k the previous week. This is for the BLS survey week containing the 12th of the month and is the lowest since late September. The 4-week moving average fell to 206k, also the lowest since late September. Consensus for NFP stands at 190k vs. 223k in December but is likely to creep higher if other labor market readings come in firm as well. Bottom line: the U.S. labor market remains firm and the Fed has a lot of work still to do. Until the labor market weakens, it’s hard to see how wages will fall enough for the Fed to feel comfortable pivoting.

EUROPE/MIDDLE EAST/AFRICA

The account of the ECB’s December 15 meeting tilted hawkish. “A large number of members initially expressed a preference for increasing the key ECB interest rates by 75 bp, as inflation was clearly expected to be too high for too long and prevailing market expectations and financial conditions were plainly inconsistent with a timely return to the ECB’s 2% inflation target.” However, “Some of these members, nonetheless, expressed their willingness to agree on a 50 bp rate rise if a majority were to support….the enhanced message that the Governing Council would continue raising rates significantly at a sustained pace, which were also part of the proposal.” Regarding Quantitative Tightening, “Some members expressed a preference for reducing the APP portfolio at a faster pace or for terminating reinvestments altogether. It was cautioned, however, that too fast a pace of reduction could lead to the re-emergence of bond market fragmentation, which could make further interest rate increases more difficult to pursue.”

ECB President Lagarde remains hawkish. She stressed again that “We have to also stay that course of resilience that we observed in 2022. ‘Stay the course’ is my mantra for monetary-policy purposes.” Lagarde and other bank officials are clearly pushing back against recent reports that the bank is likely to slow its pace at the March meeting. ECB tightening expectations are little changed. WIRP suggests a 50 bp hike February 2 is nearly priced in, followed by 65% odds of another 50 bp hike March 16. A 25 bp hike May 4 is about 75% priced in, while a last 25 bp hike in Q3 is about 75% priced in that would see the deposit rate peak near 3.5% vs. 3.75% last week. If inflation continues to slow, we think the expected peak rate could move down to 3.25% or perhaps even to 3.0%, which is where it stood back in mid-December.

The U.K. reported very weak December retail sales. Headline came in at -1.0% m/m vs. 0.5% expected and a revised -0.5% (was -0.4%) in November while sales ex-auto fuel came in at -1.1% m/m vs. 0.4% expected and -0.3% in November. As a result, the y/y rates worsened. Late yesterday, January GfK consumer confidence came in at -45 vs. -40 expected and -42 in December. We are unsure why consensus saw any sort of improvements in either the sales or sentiment, as the headwinds on the U.K. economy continue to grow.

Bank of England Governor Bailey sounded a bit less hawkish. Yesterday, he said “What we think is the most likely outcome is that (inflation) will fall quite rapidly this year, probably starting in the late spring, and that has a lot to do with energy pricing.” Regarding wage pressures, Bailey said “At the moment I think the news on pay - yes there are some signs that if anything it is still rising a bit - but some of the forward looking surveys of earnings and pay are not as strong as that actually.” BOE tightening expectations remain steady. WIRP suggest over 80% odds of a 50 bp hike February 2, while a 25 bp hike March 23 is now priced in rather than 50 bp previously. After that, a 25 bp hike in either Q2 or Q3 is priced in that would see the bank rate peak near 4.5% vs. 4.75% last week. Odds of another hike to 4.75% remain less than 15%.

ASIA

Japan reported December national CPI. Headline came in as expected at 4.0% y/y vs. 3.8% in November, core came in as expected at 4.0% y/y vs. 3.7% in November, and core ex-energy came in a tick lower than expected at 3.0% y/y vs. 2.8% in November. These were the highest readings since 1981 and yet the BOJ forecasts core inflation to return back below the 2% target in both FY23 and FY24. This seems more and more unlikely without a significant shift in monetary policy. PPI accelerated to 10.2% y/y in December, a tick below the cycle high from September and suggesting further upward pressure on CPI in the coming months.

BOJ tightening expectations have steadied. WIRP suggests nearly 15% odds of liftoff for the next meeting March 9-10, rising to nearly 60% for the April 27-28 meeting and fully priced in for the June 15-16 meeting. If markets continue to test the BOJ’s commitment to YCC, we still think it’s quite possible that it abandons YCC at the March meeting in order to set up liftoff at the April or June meetings. This is the basic roadmap for tightening that’s been well-established by the Fed. Of note, the BOJ’s balance sheet has continued to grow as a result of YCC but we do not foresee Quantitative Tightening until 2024 at the earliest.

China’s commercial banks kept their Loan Prime Rates steady, as expected. China will be on holiday all next week for the Lunar New Year holiday. Of note, the PBOC injected a net CNY1.97 trln ($291 bln) of liquidity into the system this week via open market operations, a record amount. We expect further stimulus in Q1 as the economy is likely to continue struggling despite the reopening steps already taken.

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