Dollar Steady as Risk Off Impulses Ebb

May 13, 2022

U.S. yields are moving higher as risk off sentiment ebbs; Fed Chair Powell helped boost sentiment yesterday by downplaying risks of a 75 bp move; U.S. data calendar is light; the heavy slate of UST issuance ended on a strong note; Mexico hiked rates 50 bp to 7.0%, as expected, but hinted at larger moves ahead

Reports suggest PM Minister Johnson has ordered his government to slash U.K. civil service jobs in order to offset possible tax cuts; BOE tightening expectations have cooled; eurozone reported March IP; ECB tightening expectations remain subdued; Russia reports April CPI

BOJ Governor Kuroda reiterated his dovishness; HKD continues to trade at the weak end of its trading band; Hong Kong just cut its 2022 growth forecast to 1-2% vs. 2.0-3.5% previously; China reported weak April new loan and money data

The dollar is little changed as risk off sentiment ebbs with a little help from Powell.  DXY is trading near 104.729, just below yesterday’s new cycle high near 104.925.  We continue to target the 2002 high near 107.  The euro is trading near $1.0390, just above yesterday’s new cycle low near $1.0355.  We continue to look for a break below the January 2017 low near $1.0340, at which point we have to start talking about parity.  USD/JPY is trading back above 129 as risk off impulses ebb and should continue weakening.  BOJ is showing no signs of a policy pivot (see below) and so we continue to target the January 2002 high near 135.15.  Sterling is trading near $1.2215, just above yesterday’s new cycle low near $1.2165.  We look for a test of the May 2020 low near $1.2075. After that, we have to start talking about the March 2020 low near $1.1410.  With U.S. yields starting to rise again as risk off impulses ease, the dollar should continue to benefit from the so-called dollar smile.

AMERICAS

U.S. yields are moving higher as risk off sentiment ebbs.  The 10-year yield is trading near 2.90%, up from yesterday’s low near 2.81% but still below the cycle high near 3.20% from Monday.  The 10-year breakeven inflation rate fell as low as 2.59% yesterday but has since recovered to 2.63%.  As a result, the real 10-year yield is back up to 0.27% and just shy of the 0.34% cycle high from earlier this week.  Similarly, the 2-year UST yield is trading near 2.58%, up from yesterday’s low near 2.51% but still below the peak near 2.85% from last week.  Market expectations for Fed tightening picked up a bit after the CPI data but have since fallen back.  The swaps market still sees a terminal Fed Funds rate near 3.0%, right where it started the week.   

The dollar is holding steady today despite the modestly higher yields.  If yields continue to rise as we expect, the dollar should eventually benefit more.  The 2-year differentials with Germany, Japan, and the U.K. are likely to continue moving in the dollar’s favor.  Price action this week perfectly illustrates the so-called dollar smile whereby it gains during periods of risk off as well as in periods of strong U.S. data and rising yields.  Either way, the dollar’s climb is likely to continue for the time being. 

Fed Chair Powell helped boost sentiment yesterday by downplaying risks of a 75 bp move.  Just as he said at the most recent FOMC meeting, the Fed isn’t “actively considering” such a move.  He said that “if the economy performs about as expected, that it would be appropriate for there to be additional 50 bp increases at the next two meetings.”  He did offer a caveat, noting that “If things come in better than we expect, then we’re prepared to do less. If they come in worse than when we expect, then we’re prepared to do more.”  Still, we remain surprised that Powell continues to keep 75 bp off the table when so many of his colleagues are trying to put it back on the table.  While 75 bp isn’t our base case, we recognize that the situation may evolve in such a way that it becomes necessary.  Never say never.  Kashkari and Mester speak today. 

The U.S. data calendar is light.  April import/export prices and preliminary May University of Michigan consumer sentiment will be reported.  Michigan headline is expected at 64.0 vs. 65.2 in April, driven mostly by an expected one point drop in the expectations component to 61.5.  Current conditions are expected to fall a tick to 69.3.  Keep an eye on 1-yaer inflation expectations, which are expected to rise a tick to 5.5%. 

The heavy slate of UST issuance ended on a strong note.  $22 bln of 30-year bonds were sold yesterday.  Indirect bidders took up 69.7 vs. 65.2% at the previous auction, the bid/cover ratio was 2.38 vs. 2.30, and the high yield was 2.997% vs. 2.815%.  This follows similarly strong demand for $36 bln of 10-year notes and $45 bln sale of 3-year notes.  The results would seem to validate the notion that despite ongoing uncertainty about Fed policy and the inflation trajectory, investors were enticed to buy this week by the higher yields. 

Banco de Mexico hiked rates 50 bp to 7.0%, as expected.  However, it hinted at larger hikes ahead as it noted “Given the growing complexity in the environment for inflation and its expectations, taking more forceful measures to attain the inflation target may be considered.”  The vote was 4-1, with Deputy Governor Espinosa dissenting in favor of a 75 bp hike.   Minutes to this meeting will be released May 26.  Next policy meeting is June 23 and we expect the bank to maintain its 50 bp pace then.  However, risks of a hawkish  surprise will rise if the inflation trajectory continues to worsen.   

EUROPE/MIDDLE EAST/AFRICA

Reports suggest Prime Minister Johnson has ordered his government to slash U.K. civil service jobs in order to offset possible tax cuts.  He reportedly said at a cabinet meeting yesterday that the civil service needs to get back to its 2016 headcount, which would translate into cuts of around 90,000 jobs or nearly 20%.  Coming at a time of great hardship for Britons, this strikes us as entirely tone deaf.  Despite the usual complaints about a massive bureaucracy, U.K. civil servants are generally well-regarded and well-respected.  The fact that these cuts are even being contemplated won’t play well; if they were to actually happen, we would expect huge payback at the polls.

Bank of England tightening expectations have cooled.  WIRP suggests another 25 bp hike is priced in for the next meeting June 16.  Looking ahead, the swaps market is pricing in 125 bp of total tightening over the next 12 months that would see the policy rate peak near 2.25% vs. 2.5% at the start of this week.  The March real  sector data came in weak and April will be even worse, while inflation continues to rise.  April CPI data will be reported next Wednesday, with headline expected at a whopping 8.9% y/y vs. 7.0% in March.  Therein lies the dilemma for the BOE, which at this point appears unwilling to confront the inflation problem head on as the Fed is trying to do.  This is why we remain negative on sterling. 

Eurozone reported March IP.  It came in at -1.8% m/m vs. -2.0% expected, while the y/y rate came in at -0.8% vs. -1.0% expected and a revised 1.7% (was 2.0%) in February.  IP has contracted y/y in three of the past five months, and high base effects are likely to lead to negative numbers for April, May, and June as well.  Unfortunately, it’s more than just base effects as recent eurozone data point to outright weakness, particularly in Germany.  The real sector data will be coming in weak just as the ECB ends QE in June and hikes rates in July.

ECB tightening expectations remain subdued.   While liftoff July 21 remains fully priced in, the swaps market is only pricing in 125 bp of tightening over the next 12 months followed by another 50 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 this week.

Russia reports April CPI.  Headline inflation is expected at 17.99% y/y vs. 16.69% in March.  If so, it would be the highest since January 2002 and further above the 4% target.  Yet the central bank delivered two 300 bp cuts in April that took the policy rate down to the current 14.0%.   Next scheduled policy meeting is June 10 but the bank won’t hesitate to cut intra-meeting if circumstances allow. The bank may feel emboldened to cut again soon by the firming ruble, but that exchange rate is meaningless as long as foreign investors are prohibited from selling local assets and repatriating the proceeds.   

ASIA

Bank of Japan Governor Kuroda reiterated his dovishness.  He stressed that monetary stimulus must stay in place to support the economy as it’s still recovering from the pandemic.  Kuroda predicted that a rate hike would hurt the economy and bank lending and profitability may fall.  Regarding the weak yen, Kuroda said it’s “extremely important” for exchange rates to move in a stable manner and reflect economic fundamentals, and that the recent rapid weakening of yen adds to the uncertainties.  Lastly, he emphasized that it would be inappropriate to consider an exit from easy policy during his term as governor.  This lines up with our view that easy policy is maintained until his term ends next spring, allowing his successor to take up the debate.

HKD continues to trade at the weak end of its trading band.  HKMA has so far spent $1.08 bln (and counting) to defend the peg this week.  Given souring sentiment on EM and China, we expect HKD to remain at or near the 7.85 limit well into H2, which will require ongoing intervention.  While this will undoubtedly lead to tighter liquidity and slower growth in Hong Kong , the peg will hold.  Please see our recent Thoughts on the HKD Peg for an in-depth look.  

The Hong Kong government just cut its 2022 growth forecast to 1-2% vs. 2.0-3.5% previously.  It noted that “The worsened global economic prospects may continue to weigh on Hong Kong’s export performance.  In the face of mounting inflation, major central banks are expected to expedite their monetary policy tightening, further dampening global economic growth.”  What was left unsaid is that a protracted defense of the HKD peg will add to the headwinds as local interest rates spike.  IMF forecasts 0.5% growth this year, while Bloomberg consensus sees 1.2%.

China reported weak April new loan and money data.  New loans came in at CNY645 bln vs. CNY1.53 trln expected and CNY3.13 trln in March, while aggregate financing came in at CNY910 bln vs. CNY2.2 trln expected and CNY4.65 trln in March.  New loans were the lowest since December 2017, while aggregate financing was the lowest since February 2020.  Commenting on the data, the PBOC noted that “the impact of the outbreak on the economy became clearer, while a shortage of key materials and rising productions costs added to the woes.”  Despite pledging more aggressive stimulus, policymakers have so far done little to boost the economy.  PBOC sets its 1-year MLF rate this Monday and consensus sees it remaining at 2.85%.  However, nearly half of the 25 analysts polled by Bloomberg see between 5-15 bp of easing.  

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