Dollar Steady Ahead of ECB Decision

July 21, 2022

It’s all about the ECB today; regional Fed manufacturing surveys for July will continuing rolling out; the U.S. housing sector continues to weaken; Canada reported June CPI data yesterday
The ECB is widely expected to hike rates 25 bp; we see four possible outcomes; Italian politics have entered a dangerous new phase; the U.K. political outlook has gotten some clarity but the next Tory leader will inherit a terrible situation; South Africa is expected to hike rates 50 bp to 5.25%; Turkey kept rates steady at 14.0%, as expected
The two-day BOJ meeting ended with a dovish hold; Japan also reported June trade data; Indonesia kept rates steady at 3.5%, as expected

The dollar is treading water ahead of the key ECB decision due out shortly. DXY is trading steady near 107.066. Despite notions of a possible 50 bp move by the ECB, the euro rally ran out of steam near $1.0275 and is currently trading below $1.02. We see four potential outcomes tomorrow, most of them euro-negative (see below). The weakening trend in the yen has resumed after the dovish hold from the BOJ (see below), with USD/JPY trading as high as 138.90 and coming up on a test of the new cycle high near 139.20 from last week. With Governor Kuroda showing little concern about the yen today (see below), we continue to believe that the pair will eventually test the August 1998 high near 147.65. The sterling rally ran out of steam near $1.2045 and it continues to trade below $1.20. When all is said and done, we believe the U.S. economy will prove to be more resilient than the rest of the world and so we look for continued dollar gains.


It’s all about the ECB today. As a result, U.S. yields continue to move sideways ahead of next week’s FOMC meeting. The 2-year yield is trading around 3.24%, while the 10-year is holding near 3.04%. With no Fed speakers until Chair Powell’s press conference next Wednesday, bond markets are likely to remain in a holding pattern. On top of that, there are no top shelf U.S. data releases until next week. Thus, we are left looking at the other side of the dollar trade and it’s not pretty. The eurozone and the U.K. are both heading towards recession, while weaker China growth is likely to continue weighing on EM and the commodity exporters. We continue be believe that despite growing risks to the U.S. outlook, it remains head and shoulders above the rest of the world and that is dollar-positive.

Regional Fed manufacturing surveys for July will continuing rolling out. Philly Fed today is expected at 0.8 vs. -3.3 in June. Last week, the Empire survey came in at 11.1 vs. -1.2 in June. S&P Global reports its preliminary July PMI readings tomorrow and will give a broader take of the state of the U.S. economy. Weekly jobless claims and June leading index will also be reported. Initial claims will be of interest as they are for the BLS survey week containing the 12th of the month. Consensus sees 240k vs. 244k the previous week. Elsewhere, the leading index is expected at -0.6% m/m vs. -0.4% in May. If so, it would be the fourth straight drop and five of the past six months. Of course, the economy is slowing as that is what the Fed is trying to do. The big question here is whether the Fed can slow the economy enough to lower inflation without triggering a recession.

The housing sector continues to weaken. Yesterday, existing home sales came in weaker than expected, falling -5.4% m/m vs. -1.1% expected and -3.4% in May. This led the y/y rate to fall to -14.2%, the lowest since May 2020. New and pending home sales will be reported next week and are expected to show similar weakness. Again, this is what Fed rate hikes are designed to do and so we don’t want to put too much emphasis on a weaker housing sector. The national average 30-year fixed rate mortgage peaked near 6.04% June 21 and subsequently fell to 5.57% in early July. It has since crept higher to around 5.84% currently and so there is little relief seen for housing in the coming months.

Canada reported June CPI data yesterday. Headline came in at 8.1% y/y vs. 8.4% expected and 7.7% in May. While this was a rare downside miss for CPI, inflation was still the highest since January 1983 and further above the 1-3% target range. The Bank of Canada surprised markets with a 100 bp hike to 2.5% last week vs. 75 bp expected. After the CPI data, WIRP still shows a 75 bp hike to 3.25% is nearly 75% priced in. Looking ahead, the swaps market is still pricing in 125 bp of tightening over the next 6 months that would see the policy rate peak near 3.75%. Similar to what’s priced in for the Fed, the swaps market then sees the BOC starting an easing cycle over the subsequent 6 months.


The European Central Bank is widely expected to hike rates 25 bp. We note some risks of a hawkish surprise (see below), with markets pricing in around 33% odds of a 50 bp move. Note that the decision time has been moved to 815 AM ET from 745 AM ET previously, while the press conference has been moved to 845 AM ET from 830 AM ET previously. Updated macro forecasts won’t be released until the September 8 meeting. As usual, Madame Lagarde’s press conference is likely to provide the fireworks, whether good or bad. We know that the divide between the hawks and doves remains wide and so we are braced for disappointment. Looking ahead, a 50 bp hike is fully priced in for September, with around 60% odds of a 75 bp move. Expected moves at the subsequent meetings are 50 bp on October 27 and 25 bp on December 15 that would take the policy rate above 1.0% by year-end. Looking ahead, the swaps market is now pricing in 200 bp of tightening over the next 12 months that would see the deposit rate rise to 1.5%. After that, there are some odds of another 25 bp hike.

We see four possible outcomes today. The best case outcome for the euro would be a 50 bp hike and the announcement of an aggressive anti-crisis tool, while the worst case would be a 25 bp hike and further delays to the tool. In between would be a 50 bp hike and no tool or a 25 bp hike and an aggressive anti-crisis tool. We think the best case outcome is highly unlikely (15%), as is a 25 bp hike and aggressive anti-crisis tool (15%). As such, we are left with the worst case outcome of a 25 bp hike and no tool (35%) and a 50 bp hike with no tool (35%) as the most likely outcomes. While a 50 bp hike might give the euro a knee-jerk boost, the fact that the ECB still cannot come up with a credible anti-crisis tool should eventually weigh on the single currency. Of course, any bond-buying tool will immediately face legal challenges in Germany.

Italian politics have entered a dangerous new phase. After the League, Forza Italia, and Five Star all refused to take part in the confidence vote yesterday, the government has collapsed as Draghi tendered his resignation once again. He will stay on as caretaker until a new government is sworn in but ironically, Draghi won the confidence vote by a 95-38 margin in the 315-seat Senate. This is the worst possible outcome, to state the obvious. There was simply no way that Draghi could stay on after this latest slap in the face and so it appears very likely that snap elections will have to be held this fall. We await President Mattarella’s decision to dissolve parliament and set a date. It remains to be seen whether an incoming government will be able to agree on the economic reforms needed to unlock EUR200 bln in EU aid. Italian spreads to Germany have risen to 228 bp, the highest since mid-June and likely to test that month’s high near 242 bp. If the ECB disappoints by not announcing detail of its anti-crisis tool, this spread is likely to move significantly higher than that.

The U.K. political outlook has gotten some clarity. Sunak will face Truss in the run-off vote. After running second for every earlier round of voting, Mordaunt was overtaken by Truss in the final round 113-105. Sunak ended with 137 votes. The two will now make their case to an estimated 175k Tory party members before the winner is announced September 5. Both were of course members of Johnson's cabinet but Sunak was the first to resign while Truss supported him until the end. We think the biggest difference between the two will be Brexit. Sunak voted for Brexit and Truss voted to remain, but the latter has since become a hardline Brexiteer with her efforts to unilaterally rewrite parts of the deal.

The next Tory leader will inherit a terrible situation. They will have to deal with a likely recession, high inflation, and rising borrowing costs for the government. Earlier today, June PSNB ex-banking groups came in at GBP22.9 bln vs. GBP24.0 bln expected and a revised GBP12.6 bln (was GBP14.0 bln) in May. That means that total borrowing for the first three months of FY22/23 came in at GBP55.4 bln, GBP3.7 bln more than the Office for Budget Responsibility forecast back in March. With the Bank of England expected to continue tightening, this will only get worse even as voters are likely to clamor for more aid and businesses ask for more tax relief. It will be hard to square this circle but is likely to be another key difference between Sunak and Truss; Sunak favors fiscal prudence while Truss favors tax cuts. The big question of course is whether either one of them can turn things around before the next general election that must be held by January 2025. Stay tuned.

South African Reserve Bank is expected to hike rates 50 bp to 5.25%. However, over a third of the 20 analysts polled by Bloomberg look for a larger 75 bp move. Yesterday, June CPI came in higher than expected with headline at 7.4% y/y vs. 6.5% in May and core at 4.4% y/y vs. 4.1% in May. Headline was the highest since May 2009 and further above the 3-6% target range. At the last meeting May 19, the bank hiked rates 50 bp to 4.75%, as expected. It flagged further hikes as its models showed the policy rate at 5.30% by year-end, 6.21% by end-2023, and 6.74% by end-2024. We expect the updated model to show an even steeper tightening path. The swaps market is pricing in 300 bp of tightening over the next 12 months that would see the policy rate rise to 7.75%, followed by another 75 bp of tightening over the subsequent 24 months.

Turkey central bank kept rates steady at 14.0%, as expected. There was a bit of a relief rally after the last meeting June 23 when the bank kept rates steady, but we are not seeing that today as the lira continues to weaken after the decision. The economy is nearing a tipping point, as the growing twin deficits are crying out for a policy response. If nothing else, interest rates have to move higher in order to encourage financing of both the budget and current account deficits. Rate hikes will only happen after the nation enters a balance of payments crisis. USD/TRY has been quietly moving higher to trade at the highest level since December 20 and is on track to test that day’s high near 18.36, but a full-blown crisis would easily lead to significant new highs in this currency pair.


The two-day Bank of Japan meeting ended with a dovish hold. As we expected, the macro forecasts were tweaked but do not signal a shift anytime soon from its current ultra-dovish stance. Governor Kuroda emphasized that “We have no intention at all of raising rates under the yield curve control framework. We also have zero intention of expanding the 0.25% range on either side of the yield target. Right now, we need to continue to tenaciously pursue monetary easing.” A policymaker can’t get any more explicit than that and we maintain our view that current policy settings will be maintained through the end of his term next spring. Kuroda also touched on the exchange rate, noting that “If you were serious about stopping the weaker yen just with rate increases, you would need significant hikes and they would be very damaging to the economy.”

If the ECB hikes later today as expected, the BOJ will be the major outlier in a world of rising rates. We expect the market to eventually test the bank’s resolve to maintaining YCC, something that hasn’t happened since mid-June. That said, we believe the BOJ has unlimited firepower here and is unlikely to blink. Of course, the yen is likely to remain under pressure but as Kuroda’s comments suggest, policymakers accept this as the cost of running ultra-dovish policy. USD/JPY continued to creep higher and should soon test the mid-July high near 139.40. If the pair gets above the psychological 140 level, there are really no major targets until the August 1998 high near 147.65.

Japan also June trade data. Exports rose 19.4% y/y vs. 17.0% expected and 15.8% in May, while imports rose 46.1% y/y vs. 46.3% expected and 48.9% in May. This resulted in an adjusted deficit of -JPY1.93 trln and has been in deficit since June 2021. Because of its net creditor status, overseas investment income has kept the current account in surplus but that has been narrowing significantly. The OECD forecasts this surplus narrowing to 1.5% of GDP this year and 1.2% next year vs. 2.8% in 2021. At the margin, this is negative for the yen.

Bank Indonesia kept rates steady at 3.5%, as expected. However, over a third of the 36 analysts polled by Bloomberg looked for liftoff with a 25 bp hike to 3.75%. Governor Warjiyo noted that although headline inflation is now above the 2-4% target range, it is expected to return to target next year. He added that core inflation will remain within that range. Warjiyo said the bank will stabilize the rupiah through FX intervention in the spot and forward markets if needed. Earlier this month, USD/IDR traded as high as 15,075, the weakest since May 2020 but still well below the March 2020 high near 16,625. Lastly, Bank Indonesia said it will continue its bond sales to mop up liquidity and allow money market interest rates to rise. Next policy meeting is August 23 and the bank seems to be in no hurry to hike rates. Let’s see how the July CPI data come in before making a call on policy changes then.

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